1040 Preparation and Planning 6: Gross Income: Business

1040 Preparation and Planning 6: Gross Income: Business, Farm, and Rental Income (2020) ©2019, CCH Incorporated. All Rights Reserved. 1 of 102

1040 Preparation and Planning 6: Gross Income: Business, Farm, and Rental Income (2020) Welcome to 1040 Preparation and Planning 6: Gross Income: Business, Farm, and Rental Income and Expenses (2020) This course is developed by Wolters Kluwer, in cooperation with Sidney Kess and Barbara Weltman. This course looks at Schedule C, farm income and expenses, on Schedule F, and rents and royalties on Schedule E. To navigate this course, use the navigation arrow buttons to move forward or

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Learning Objectives Upon completing this course, you should be able to:

Complete Schedule C or C-EZ

Determine eligibility for and report deductions on a range of business expenses

Report deductions for travel-away-from-home costs

Figure meal cost limitations

Calculate deductions for business vehicle use

Figure the home office deduction

Explain property depreciation, first-year expensing, bonus depreciation, and depreciation recapture

Apply the rules for amortization, depletion, different types of losses, and bad debts

Identify expenses subject to amortization

Figure depletion deductions

Apply the limits on trade or business losses

Determine net operating losses

Determine whether a debt is a business or nonbusiness bad debt

List special deductions for farming activities

Apply the passive activity loss rules to businesses and rental activities

Determine when losses from the rental of a home are deductible

Figure the qualified business income deduction

Reference Material

IRS Forms and Publications

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Forms:

Form 461: Limitation on Business Losses

Form 1040: U.S. Individual Income Tax Return

Form 1040-SR, U.S. Tax Return for Seniors

Schedule A (Form 1040 or 1040-SR), Itemized Deductions

https://www.irs.gov/pub/irs-dft/f461--dft.pdf

https://www.irs.gov/pub/irs-dft/f461--dft.pdf

https://www.irs.gov/pub/irs-pdf/f1040.pdf


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Schedule C (Form 1040 or 1040-SR), Profit or Loss from Business (Sole Proprietorship)

Schedule E (Form 1040 or 1040-SR), Supplemental Income and Loss

Schedule F (Form 1040 or 1040-SR), Profit or Loss From Farming

Form 1040-X: Amended U.S. Individual Income Tax Return

Form 1045: Application for Tentative Refund

Form 4562: Depreciation and Amortization (Including Information on Listed Property)

Form 4797: Sales of Business Property

Form 5213: Election To Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit

Form 6198: At-Risk Limitations

Form 8582: Passive Activity Loss Limitations

Form 8829: Expenses for Business Use of Your Home

Form 8995, Qualified Business Income Deduction Simplified Computation

Form 8995-A, Qualified Business Income Deduction

Schedule A (Form 8995-A), Specified Service Trades or Business

Schedule B (Form 8995-A), Aggregation of Business Operations

Schedule C (Form 8995-A), Loss Netting and Carryforward

Schedule D (Form 8995-A), Special Rules for Patrons of Agricultural or Horticultural Cooperatives

Publications:

Publication 225: Farmer’s Tax Guide

Publication 334: Tax Guide for Small Business (For Individuals Who Use Schedule C)

Publication 527: Residential Rental Property (including Rental of Vacation Homes)

Publication 529: Miscellaneous Deductions

Publication 534: Depreciating Property Placed in Service Before 1987

Publication 535: Business Expenses

Publication 536: Net Operating Losses for Individuals, Estates, and Trusts

Publication 544: Sales and Other Dispositions of Assets

Publication 547: Casualties, Disasters, and Thefts

Publication 583: Starting a Business and Keeping Records

Publication 587: Business Use of Your Home (Including Use by Day-Care Providers)

Publication 925: Passive Activity and At-Risk Rules

Publication 946: How to Depreciate Property


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Publication 2194: Disaster Resource Guide for Individuals and Businesses Note Final versions of all 2019 tax forms, schedules, and other publications have not been released. We have used the most current versions available at the time this course was posted. Additional tax legislation, court decisions and IRS pronouncements could affect 2019 returns.

Business Income and Expenses Taxpayers engaged in a trade, business, or profession must include in gross income any net profit (or loss) derived from operating that trade, business, or profession. Schedule C is filed by sole proprietorships, spouses in a family business that opt to file this schedule, and one-member limited liability companies that have not elected to be taxed as corporations. The net profit is computed on Schedule C, which is attached to the taxpayer’s Form 1040 or 1040-SR. Before 2019, certain sole proprietors were able to file a simplified Form 1040-EZ, but this is no longer used.

Spousal Businesses Spouses who file jointly, co-own a business, and each materially participate in it can choose not to file a partnership return, Form 1065, and two Schedule K-1s. Instead, they each file a separate Schedule C and report their shares of net earnings for self-employment tax purposes. To determine net profit, all receipts from sales, fees, or other sources should be totaled. Then, all allowable expenses and other deductions are deducted from that total. To be deductible, expenses must be “ordinary and necessary” to carry on the trade or business.




The expenses must be directly related to, or connected with, the trade, business, or profession, and must have been paid (if the taxpayer is on the cash basis) or incurred (if the taxpayer is on the accrual basis) during the taxable year. The timing of when to claim a deduction depends on a taxpayer’s method of accounting. Net profit not only is the amount of earnings included in gross income, it is also the figure used to determine self-employment tax.

Business Deductions Unless otherwise covered by a specific section of the Tax Code, a business expense is deductible if it is “ordinary and necessary.” Ordinary An expense is considered “ordinary” if incurring it is a common and accepted practice in the taxpayer’s field of business. Necessary It is considered “necessary” if it is appropriate and helpful in developing and maintaining the trade or business. Thus, an expense need not be essential or indispensable in order to be deductible.

Reasonableness of Salaries In addition to being ordinary and necessary, the amount expended for salaries must be reasonable in relation to the services performed. The courts have disallowed excessive compensation paid to members of a taxpayer’s family, considering this a mere device to spread taxable income among many people. The regulations define “reasonable compensation” as an amount that would ordinarily be paid for like services by like enterprises under like circumstances.


Determining Reasonable Salaries

In determining whether salaries are reasonable, many factors are taken into account, the most important of which are the nature of the services rendered, the salaries paid in prior years for the same type of work, whether the salary is on a contingent basis (a larger amount may be reasonable if the compensation is contingent), and the amount the employee would have obtained from another employer for the same work. Courts have also used a “hypothetical investor” test to decide if compensation is reasonable, that is, whether an investor in the company thinks the payment is reasonable, allowing for a return to the investor.

What Constitutes a Trade or Business?

A taxpayer is considered as being “engaged in a trade or business” if the activity is one entered into with at least the expectation of making a profit and the taxpayer devotes a substantial part of his business time to it, or if the taxpayer operates it through an agent or employee who devotes a substantial part of his time to it. Thus, an individual can be engaged in more than one trade or business at the same time. On the other hand, if a taxpayer merely holds securities or other property for investment purposes, although he devotes some time to their management, the taxpayer is not considered as being engaged in a trade or business. In some cases, the ownership and management of rental property can be considered a trade or business. Expenses incurred in connection with mere investment activities are not deductible in 2018 through 2025. Miscellaneous itemized deductions, which is how investment-activity expenses are treated, are suspended during this period.


Examples of Common Ordinary and Necessary Business Expenses

The following is a list of some of the most common allowable business expenses.

Bear in mind that this listing is merely intended as a guide to what type of

expense is deductible:

Accounting and bookkeeping fees (including return preparer fees allocable

to Schedule C)

Advertising

Bad debts from reported sales or services (accrual method taxpayers only)

Bank, merchant authorization, credit card discounts, and PayPal/Amazon

Pay fees

Commissions paid

Cost of moving business to a new location

Cost of prizes awarded in contests

Depreciation

Employee benefit programs

Expenses incurred in attending business conventions

Heat, light, power, telephone, and mobile devices, Internet access, and

other utility costs

Insurance premiums

Legal fees

Licenses and regulatory fees

Meals and business gifts

Office supplies

Penalties for nonperformance of a contract

Postage and freight charges

Rents paid

Repairs and maintenance

Travel expenses

Wages and salaries paid to employees

The cost of business interest generally is deductible only to a certain extent

unless an exemption to this rule applies (Code Sec. 163(j)). More specifically, the

business interest expense deduction for the year is limited to the sum of:


(1) business interest income, (2) 30% of the adjusted taxable income, and (3)

floor plan financing interest expense. However, small businesses meeting a gross

receipts test (in 2019 it means those with average annual gross receipts for the 3

prior years under $26 million) are exempt from this limitation. Farming

businesses and real estate business with gross receipts over this threshold can

elect to be exempt, providing they depreciate their property using the Alternative

Depreciation System (ADS) for any farming property the taxpayer owns with a

recovery period of 10 years or more.

Start-up Expenses

Start-up expenses are expenses incurred to decide whether to go into business and which business to enter. These are discussed later in this course under Amortization.

Advertising Expenses Advertising expenses are deductible if they are reasonable and bear a reasonable relationship to the taxpayer’s business activities. Such expenses are not deductible if made to promote or defeat legislation. Expenditures for “institutional” or “goodwill” advertising to keep the taxpayer’s name before the public are generally deductible as ordinary and necessary business expenses. Donations to business organizations, as well as advertisements in charity-sponsored journals, newspapers, and so on, are deductible as business expenses if made with reasonable expectation of financial return commensurate with the amount of the donation. Donations to tax-exempt organizations that are made with no expectation of financial return are an owner’s personal charitable contributions claimed on his or her Schedule A to the extent allowed there.


Business Bad Debts

A business bad debt is one that arises out of a debt that was originally created or acquired in the taxpayer’s trade or business. Such debts may be deducted in determining adjusted gross income if they become completely worthless or if they are partially worthless, provided that the uncollectible portion can be determined with reasonable certainty (Code Sec. 166). Example Richard Hamilton, a jeweler reporting on the accrual basis, sold a $2,000 diamond bracelet to a customer on credit. The customer filed for bankruptcy, and it is reasonably certain that Richard will receive no more than 50% of the amount due him. He may charge off $1,000 (50% of $2,000) as a bad debt.

A deduction on account of a partially worthless debt is allowable only to the extent that the specific debt is charged off on the books during the taxable year. If no charge-off is made, the entire debt is deductible when it becomes totally worthless. The deduction for business bad debts is reported on Schedule C (or Schedule F, for bad debts connected with farming).

Loans by Shareholder-Employees

Individuals who make a loan to a corporation for which they work and in which they own stock may have difficulty in deciding whether a bad debt is a business bad debt or a nonbusiness bad debt. A loan by a shareholder is treated as a nonbusiness bad debt made to protect an investment. A loan by an employee is treated as a business bad debt made to protect a salary.


Whether a loan by a shareholder-employee is a business or nonbusiness bad debt depends on the dominant motive for making the loan (see e.g., Haury, CA-8, 2014-1 USTC ¶50,282, where the dominant motive was to protect his investment, making it a nonbusiness bad debt).

Examples and Pitfall Example Sidney Marcus, an elderly businessperson, formed his own corporation when his employer decreased his responsibilities. He did so to obtain sufficient salary income, as well as investment opportunities. He loaned money to his new corporation and guaranteed a line of credit on which he suffered a loss.

He was actively involved in the day-to-day management of the company and continued to be involved even after the sale of his controlling interest and after his chance for significant capital return was lost. Therefore, the dominant motive in making the loan was to protect his compensation as an officer and employee of the corporation rather than to protect his investment as a shareholder in the company. This was a business bad debt. Example John Carter, an independently wealthy individual, started a corporation by making an investment and also loaning money to the corporation. He was not repaid. His salary from the corporation was $30,000, while his outside income was $1 million. His dominant motive was protection of his investment and not job security. This was a nonbusiness bad debt. Pitfall A shareholder-employee who has an employee business bad debt cannot deduct it in 2018 through 2025 due to the suspension of miscellaneous itemized deductions subject to the 2%-of-AGI floor. The net result is that a shareholder-employee with a business bad debt from a loan to the corporation that went sour does not reap any tax benefit from this financial loss occurring during this period.


The amount of the bad debt deduction is determined by the basis the debt would have had if it had been sold at a loss. Thus, it is not necessarily the face amount of the debt. Example Andre Anderson sold $5,000 worth of merchandise to Bob Baxter and received Bob’s note in return. Andre then sells the note to Carl Caruthers for $4,500. Subsequently, Bob goes bankrupt, and the note becomes totally worthless. Carl’s bad debt deduction is $4,500, the amount he paid for the note.

Recovery of Bad Debts

If a taxpayer deducted a bad debt from gross income in a previous year, and later recovers some or all of it, the taxpayer does not have to include the recovered amount in gross income in the year it is collected if the previous year’s deduction did not reduce the previous year’s tax (Code Sec. 111).

The Nonaccrual-experience Method

Taxpayers who use an accrual method and qualify under the rules need not accrue (include in income) any part of amounts that they receive from performing services that, on the basis of experience, will be uncollectible. This is treated as a method of accounting called the “nonaccrual-experience method.” The nonaccrual-experience method may not be used for amounts owed to taxpayers because they are engaged in activities such as:

Lending money

Selling goods Generally, the nonaccrual-experience method may not be used for amounts due for which interest or a penalty for late payment is required to be paid.


Statute of Limitations for Bad Debts The bad deduction is deductible on the return for the year of worthlessness. Instead of the usual 3-year period for filing an amended return, in the case of a bad debt, an individual has 7 years in which to file an amended return and report a bad debt. Explanation of Bad Debt Deduction on Tax Return

A taxpayer claiming a business bad debt deduction must attach a statement to the return showing:

1. The nature of the debt 2. The name of the debtor and the business or family relationship (if any) to

the taxpayer 3. When the debt became due 4. What efforts were made to collect the debt 5. How the debt was determined to be worthless

Bribes and Kickbacks

No deduction may be claimed for any payment, direct or indirect, to a person if the payment is an illegal bribe or an illegal kickback under a U.S. law or any state law that is generally enforced.

To be “illegal,” it must subject a taxpayer to a criminal penalty or the loss of a license, but it is not necessary that criminal prosecution or license loss actually occur.

The IRS has the burden of proving that the challenged payment is an illegal bribe or kickback.

There is no deduction for Medicare kickbacks, but here illegality is not relevant, and the IRS has no special burden of proof.


Planning Pointer The legality of certain payments made to foreign government officials is determined solely under the Foreign Corrupt Practices Act. Thus, a payment that is not prohibited by the FCPA, but is classified as illegal under another federal law, is deductible as a business expense.

Fines and Penalties

Fines and penalties for violating the law, such as traffic fines or penalties for building violations, are nondeductible even where incurred in connection with the taxpayer’s trade or business, and even though the violation was inadvertent. Planning Pointer Amounts constituting restitution, to come into compliance with the law, to satisfy a court order where the government is not a party, and the payment of taxes due are exempt from this bar (Code Sec. 162(f)(1)).

Lobbying Expenses

Lobbying expenses incurred to appear before congressional or legislative committees, or before senators, congressmen, or state legislators, or to submit statements are not deductible. However, there are two special rules related to the disallowance provisions. First, the disallowance provision does not apply to activities devoted solely to monitoring legislation. Second, a de minimis exception allows a deduction is allowed for in-house expenditures not exceeding $2,000. In-house expenditures are expenditures paid or incurred to influence legislation, or direct communications with a covered executive branch official in an attempt to influence the official’s actions or positions. No deduction is allowed for local lobbying expenses (Code Sec. 162(e)(2)). The disallowance extends to a pro rata portion of the membership dues of trade associations and other groups that are involved in lobbying activities.


Home Phone Service

A taxpayer who uses a landline in his or her residence for business or income production purposes may not deduct the base charge for local telephone service (e.g., charges required to be paid to obtain local telephone service for the first telephone line in the taxpayer’s residence).

Interest on Tax Deficiencies

Interest on a tax deficiency related to business income and expenses reported on Schedule C, E, or F is not deductible.

Commercial Landlord

An owner of a commercial building can deduct 60¢ or $1.80 per square foot for meeting certain energy standards, depending upon the extent of energy savings (Code Sec 179D). This provision expired at the end of 2017, but may be extended by Congress for 2019; check for any extension.

Repairs and Maintenance Costs

It is necessary to distinguish between capital expenditures and current expenses because capital expenditures are not deductible but may be recovered through depreciation over a period of years (Code Secs. 162 and 263).

Capital Expenditure

A capital expenditure represents an investment of capital either to acquire property having a useful life of more than 1 year or to increase the value of such property or to prolong its life. Examples of capital expenditures include the costs of acquiring a plant for production, building an addition to an existing structure, installing a new roof, installing a new heating system, and installing new elevators.


Commissions and legal fees incurred in buying or constructing property are also capital expenditures. The area in which the distinction between capital and current expenses is of particular importance is where money is expended on repairs, replacements, or improvements. The latter two are capital expenditures that usually must be capitalized (added to the basis of the property) and recovered (if at all) only through depreciation, while the former is an expense that entitles the taxpayer to a full current deduction. However, there are certain safe harbors that can be used to treat capital improvements as a currently deductible expense:

Safe harbor election for small taxpayers. This applies to those with average annual gross receipts of $10 million or less owning or leasing a building with an unadjusted basis of $1 million or less. The safe harbor allows a deduction of the lesser of 2% of the unadjusted basis of the eligible property or $10,000.

Safe harbor for routine maintenance. This applies to amounts paid for recurring activities (not for betterments, which are discussed next).

Repair

A "repair” is defined as an expense made to maintain the taxpayer’s business property in an ordinary, efficient operating condition, whereas an improvement materially adds to the value or utility of the property or appreciably prolongs its useful life. A capital improvement to tangible property is:

1. A betterment of the property 2. A restoration of a unit of property 3. An adaptation of the unit of property to a new or different use

Examples of repairs to real property are patching and repairing floors, repainting the insides and outsides of buildings, repairing roofs and gutters, and mending leaks.


Capital Items

Expenditures for replacements of parts of a machine, merely to maintain it in efficient operating condition, are deductible as repairs. However, if the machine is extensively overhauled, it is considered an improvement and should be capitalized. Other examples of capital items are new electric wiring, new roofs, new floors, new plumbing, and lighting improvements.

The IRS warns that taxpayers who make both repairs and improvements at the same time should segregate the repair and improvement items; otherwise, capitalization of the entire cost may be required.

Environmental Cleanup

It is not always easy to determine whether the cost of environmental cleanup is currently deductible or must be capitalized. Generally, when the cost is to restore the property to its pre-contamination condition, those restoration costs can be expensed; otherwise, they must be capitalized.

Study Question

Which of the following expenses is a deductible business expense?

Basic service charge for the first telephone line to a taxpayer’s home even if the phone is used in a deductible home office

Interest on a tax deficiency related to Schedule C

Advertising

Capital improvements to business property

Study Question

Which costs are not currently deductible?

Repairs

Advertising expenses

Rents

Capital improvements


Research and Development Expenditures

If taxpayers incur research and development expenses (R & D) in connection with their trade or business, the question of whether such expenditures should be deducted or capitalized is presented (Code Sec. 174). This full expensing rule expires at the end of 2021. In certain instances, a taxpayer may incur research and experimental expenditures before actually engaging in any trade or business activity. In such instances, the Supreme Court has applied the liberal standard of deductibility crafted by Congress in Code Sec. 174 and permitted a deduction in the year paid or incurred. Alternatively, in tax years beginning before January 1, 2022, research and experimental expenditures may be deferred and amortized. If this election is made, the expenditures are amortized:

1. Over a period of at least 60 months beginning in the month the taxpayer first realizes a benefit from the expenditures (i.e., when the product, process, etc., is first put to use in generating income), or

2. Over a period of 10 years beginning in the year the expenditure is made Example In the current year, the XYZ Company builds and equips a research laboratory at a cost of $150,000. The operating and other expenses, including depreciation, amount to $60,000. Only the $60,000 is deductible in the current year. The cost of the laboratory must be capitalized and can be recovered only through amortization. Planning Pointer There is a research tax credit that may be claimed for such costs (the credit is explained in 1040 Preparation and Planning 11: Tax Credits).

Carrying Charges, Interest, and Taxes on Real Estate

Landowners have the option to capitalize real estate taxes, mortgage interest, and deductible carrying charges on unimproved and unproductive real estate,


instead of currently deducting these expenses. This election is made each year (Code Sec. 266). Taxpayers engaged in real estate development or the construction business usually must capitalize loan interest, carrying charges and taxes, such as federal and state unemployment and Social Security taxes on the wages of their employees, as well as state and local sales taxes. However, capitalization may be made only for those expenses paid or incurred up to the time the work was completed.

Travel Expenses

Travel and entertainment expenses generally are a deductible cost of doing business. However, the way in which the deduction is handled depends on a taxpayer’s employment status and, if employed, expense arrangements with an employer.

Expenses of Self-employed Persons

Self-employed individuals deduct the cost of business travel and entertainment directly from gross income. More specifically, such expenses are entered directly on Schedule C or Schedule C-EZ and offset self-employment income. Pitfall Through 2025, employees cannot deduct business expenses as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor; such deduction has been suspended. Planning Pointer If there is an “accountable plan” with an employer (explained later), then advances and reimbursements to employees are not includible in gross income.

If, however, the plan is a “nonaccountable plan,” then advances and reimbursements are includible in gross income but expenses are not deductible in 2018 through 2025.


Accountable Plans

An accountable plan is one where an employer advances or reimburses an employee for business expenses and:

1. The expenses have a business connection (there must be a nexus between an employer’s “advance” and the business expense that the employee is anticipated to incur);

2. The employee must substantiate reimbursed expenses within a reasonable

period of time; and

3. The employee must return any excess reimbursement to the employer within a reasonable time.

Considerations for Reasonable Time

The IRS has provided the following safe harbor rules for determining when returns of excess payments under reimbursement arrangements have been made within a “reasonable time” which is either of the following:

1. Advances are made within 30 days of the expense, substantiation within 60 days, and the return of excess advances within 120 days.

2. At least quarterly, the company provides a statement of amounts paid in

excess of those substantiated, and return of excess is made by employees within 120 days of receipt of the statement.

Planning Pointer The use of accountable plans is not limited to travel and entertainment costs. It can, for example, be used to reimburse employees for tools, internet access for working at home, and other costs if the plan meets all the requirements for an accountable plan.


Types of Expenses Traveling expenses include not only the cost of transportation (automobile, bus, cab, train, and plane fares, etc.) but also the cost of meals and lodging, as well as other expenses incidental to the trip, such as the cost of sample rooms, telephone, telegraph, public stenographers, laundry, and cleaning (Code Sec. 162(a)(2)). While the cost of business travel is always deductible, other travel expenses (meals and lodging, etc.) are deductible only if incurred while the taxpayer is “away from home.” The Treasury has consistently maintained that this means away from home at least overnight and, after years of litigation, this requirement has been upheld by the Supreme Court. A taxpayer cannot deduct the cost of meals on daily trips that do not require “sleep or rest.” Thus, an executive or business owner who travels to a neighboring city and returns the same evening would be entitled to deduct only the cost of transportation, not the cost of meals. Like all other business expenses, the cost of travel is deductible only if it constitutes an “ordinary and necessary” business expense. Travel expenses incurred in attending a trade, business, or professional convention or meeting are deductible if there is a sufficient relationship between the taxpayer’s trade or business and his attendance at the convention or other meeting, so that the taxpayer is benefiting or advancing the interest of his trade or business by such attendance. The fact that attendance is voluntary and not required by the taxpayer’s employer will not disallow the deduction. If the convention is for political, social, or other purposes unrelated to the taxpayer’s trade or business, the expenses are not deductible.


Expenses that are Part Business, Part Personal

If the trip is part business and part pleasure, the traveling expenses will still be allowable if the trip is entirely within the United States and it can be shown that the primary purpose for the trip was to transact business. However, the cost of meals, lodging, and other expenses incurred during the pleasure portion of the trip are nondeductible. Example David Green, a self-employed musician, travels from New York to Miami to attend a four-day music summit at the convention center. While there, he takes a 3-day sightseeing trip to the Everglades. The cost of his New York–Miami round trip transportation, his food and lodging, and other incidental expenses during the 4 days spent in Miami on business are deductible. The cost of the sightseeing trip and the food and lodging expenses during the other 3 days are not deductible.

Traveling Expenses

If the taxpayer travels to a destination outside the United States for business purposes and engages in both business and personal activities, the transportation expenses to the destination must be allocated in proportion to the time spent for business purposes. Note, however, that the rule requiring allocation of business expenses for part-business, part-pleasure trips outside of the United States applies only to managing executives and self-employed individuals and only if:

1. The trip lasted a week or less 2. The trip lasted more than 1 week and 25% or more of the total time was

spent on personal matters

Example Travis Blue, an advertising copywriter, flies to Vancouver to attend a 5-day convention of the Direct Mail Association. After the convention is over, he takes a 10-day vacation trip throughout British Columbia.


Because the trip lasted more than one week and more than 25% of the time was spent on personal matters, he can deduct 5/15 of his New York to Vancouver round-trip transportation expenses and all expenses incurred during the 5-day stay in Vancouver. The rest of the expenses are nondeductible. Example Art Vance, an exporter, takes a 21-day trip to Europe. He spends 17 days on business and 4 days on personal matters. All his traveling expenses, with the exception of those incurred during the 4 days he spent on nonbusiness matters, are deductible because less than 25% of the time was devoted to personal matters. Per diem rates for lodging, meals and incidental expenses for travel are found at www.gsa.gov (click on “per diem rates”). The deduction for expenses of travel by cruise ship or other luxury water transportation is limited to twice the highest per diem generally allowed employees of the federal government for travel in the United States, times the number of days in transit.

Example Paul Green makes a business trip by ship from New York to England. Assuming that the voyage takes 4 days and that the highest per diem is $200, Paul’s deduction cannot exceed $1,600 ($400 per day × 4 days).

Spouse or Other Travel Companion

If a taxpayer’s spouse (or other family member or companion) accompanies the taxpayer on a business trip, expenses attributable to the spouse’s travel are not deductible unless the spouse is also an employee of the same employer and it can be adequately shown that the spouse’s presence on the trip has a bona fide business purpose. The spouse’s performance of some incidental services does not transform the spouse’s expenses into deductible business expenses.


Investment Seminars

The costs of attending conventions or seminars for investment purposes are not deductible.

Foreign Conventions Business owners and professionals may not deduct expenses for attending conventions, seminars, or similar meetings held outside the North American area unless they establish that:

1. The meetings are directly related to the active conduct of their trade or business or to their income-producing activity.

2. It is as reasonable for the meetings to be held outside the North American area as within it.

The North American area means the United States, its possessions, Puerto Rico, the Trust Territory of the Pacific Islands, Canada, and Mexico (Code Sec. 274(h)). The “North American area” also includes Antigua and Barbuda, Aruba, Bahamas, Barbados, Bermuda, Costa Rica, Curacao, Dominica, Dominican Republic, Grenada, Guyana, Honduras, Jamaica, Panama, Saint Lucia, and Trinidad and Tobago.

Cruise Ships

A limited deduction is allowed for conventions held on U.S. cruise ships. The deduction is limited to $2,000 per individual each year, but only if:

1. The convention, seminar, or meeting is directly related to your trade or business.

2. The cruise ship is a vessel registered in the United States. 3. All of the cruise ship’s ports of call are in the United States or in

possessions of the United States. No deduction is allowed for the cost of attending a convention, seminar, or similar meeting held outside the North American area unless the meeting is


directly related to your trade or business, and it is reasonable to hold the meeting outside the North American area.

Temporary Jobs Away From Home

The deduction for traveling expenses while away from home applies only if taxpayers are away temporarily. Thus, if they are working at a location away from home permanently, or for an indefinite period of time, the IRS considers the place of their business as their tax “home” and, therefore, they are not considered to be away from home. In other words, “home,” for tax purposes, means the place of the taxpayer’s principal business, not where he or she resides. On the other hand, if taxpayers are on a temporary assignment, or have taken temporary employment away from home, their travel and living expenses at their temporary place of or business are deductible. Example Carlos Batista has seasonal work in New York for 8 months of the year and earns $12,000. From January through April, he does seasonal work in Florida, where he earns $5,000. Because his tax “home” is New York, he can deduct his transportation to and from Florida, as well as his living expenses while there. If taxpayers return home from their temporary places of business during weekends, holidays, or vacation, they may deduct their traveling expenses (including meals and lodging en route) to the extent that these do not exceed the amount they would have spent for meals and lodging had they stayed. Regardless of the guidelines discussed above, no stay is considered “temporary” if it extends beyond 1 year. The IRS has indicated that a break in an assignment of 3 weeks or less is not a significant break that would stop the running of the 1-year period.


However, a break of 7 months or more would be considered significant. Also, separate infrequent or sporadic assignments may be aggregated into a single assignment for purposes of the 1-year rule under certain circumstances. Again, the IRS has indicated that work of no more than 35 days (or part days) at a temporary location within the year would not be aggregated into a single assignment and would be considered temporary even if the overall assignment lasts more than 1 year. Example Harry Morgan is a self-employed electrician assigned to two work projects, both of which are expected to last for 18 months. He’s required to visit one project once a week (52 times a year) and the other project once a month (12 times a year). The assignment to the first project is not temporary because he must spend more than 35 days there within the year and the overall assignment is more than 1 year. But the second assignment is “temporary,” so travel costs to and from there are deductible.

Study Question

Ed Aikins has a business in one city. His family lives in another city in the home he owns. For tax purposes, which city is his “home"?

The city in which he has a business.

The city in which his family lives.

The taxpayer may elect which city to call his tax home.

Neither city.

Study Question

Which of the following is not a requirement for having tax-free reimbursements under an accountable plan?

The reimbursement cannot exceed a set dollar amount.

The expenses reimbursed must have a business connection.


The employee must substantiate expenses to the employer.

The employee must return to the employer any excess reimbursements.

Commuting Expenses

The costs that taxpayers incur in commuting from their homes to their businesses are considered personal expenses and generally are not deductible. However, if they have two places of business, they are considered, for this purpose, to be in a trade or business. The cost of traveling from the first to the second work location is deductible. Planning Pointer Individuals who claim home office deductions for a home-based business activity can deduct the cost of going from home to another business location (and back) because the home is also a business location. If, for personal reasons, a taxpayer does not go directly from one location to the other, he may deduct only the amount it would have cost to go directly from the first to the second business location. Commuting costs may also be deductible where a work location is temporary and is located outside the metropolitan area where the taxpayer lives and usually works or where commuting is to a job location that is “temporary” (i.e., expected to last for less than 1 year and in fact lasts for less than 1 year).

Example Kendra McAllister, a self-employed doctor, travels between her home and her medical office, clinics, and hospitals at which she works or performs services on a regular basis. Such transportation to and from home is considered nondeductible commuting. However, travel between her office and the clinics and the hospitals is deductible. Also, if the doctor stops off to see patients before going to her office, clinics, or hospitals, then such transportation is deductible.


National Guard and reserve members who traveled more than 100 miles from home to perform services as a National Guard or reserve members can deduct their travel costs as an adjustment to gross income. If it is necessary for taxpayers to carry heavy or bulky tools or instruments to their businesses, the IRS permits deduction of their automobile expenses, but only if they would not have otherwise used their cars.

Deducting Vehicle Expenses

If taxpayers use their cars, light trucks, or vans in connection with their trade or business, all expenses incurred (including oil, gas, tires, repairs, depreciation, etc.) are deductible. In many cases, however, vehicles are used both for business and for pleasure. If so, only a proportionate part of the expenses is deductible. The deductible portion is determined on the basis of mileage for which the vehicle was used for business purposes. Alternatively, instead of deducting actual expenses, a standard mileage rate can be used.

Dollar Limits

Taxpayers using actual expenses for an automobile, light truck, or van can claim depreciation: 20% in the first year, 32% in the second year, 19.2% in the third year, 11.52% in the fourth and fifth years, and 5.76% in the sixth year (assuming the mid-quarter convention does not apply). But special dollar limits apply to so-called luxury vehicles weighing no more than 6,000 pounds to limit depreciation. The dollar limits on vehicles placed in service during 2019 are $18,100 ($10,000 if the taxpayer opts out of bonus depreciation), for the first year, $16,100 for year two, $9,700 for year three, and $5,760 for each year thereafter (Rev. Proc. 2019-26). For a vehicle purchased before September 28, 2017, but placed in service in 2019, the dollar limit for the first year (2019) is $14,900 (taking into account bonus depreciation), $16,100 for year two, $9,700 for year three, and $5,760 for each year thereafter.


Planning Pointer As a practical matter, the dollar limits are not triggered until the cost of the vehicle bought and placed in service in 2019 exceeds $90,500. The reason: regular depreciation on the vehicle would be $18,100 ($90,500 x 20%), which is the same as the dollar limit (assuming bonus depreciation is used). If a vehicle was placed in service in 2018 and bonus depreciation was used (the dollar limit was $18,000), then in 2019 and beyond, an IRS safe harbor must be used in order to claim any additional write off. Under this safe harbor, depreciation is figured using the table in Appendix A of IRS Publication 946, How to Depreciate Property (Rev. Proc. 2019-13). The safe harbor is elected simply by applying it to the return for first tax year following the placed-in-service year. If the safe harbor is not used, the no depreciation is allowed until after the vehicle’s recovery period has ended. The following is the maximum depreciation that may be claimed for a passenger car (which for entries for the 1st and 2nd tax years includes light trucks and vans) in 2019 (assuming 100% business use):

Tax Year Car Placed in Service Dollar Limit for 2019

1st tax year $18,100*

2nd tax year (e.g., a car placed in service in 2018) 16,000

3rd tax year (e.g., a car placed in service in 2017) 3,050

Each succeeding year (e.g., a car placed in service in 2016)

1,875

*$10,000 if the taxpayer opts out of bonus depreciation; $16,400 if the vehicle was bought before September 28, 2017, but placed in service in 2019, assuming bonus depreciation.

The first-year expensing limit for 2019 under Code Section 179 on vehicles weighing over 6,000 pounds but no more than 14,000 pounds is fixed at $25,500. Pitfall The IRS has noted that claiming depreciation for a car in excess of the dollar limit is one of the most common errors made on individual income tax returns.


Nonpersonal Use Vehicles

There is no dollar limit on a truck or van that has been modified to enable only de minimis personal use. For example, if a van has only a seat for the driver or the driver and a person in a jump seat, permanent shelving, or a painted sign on the exterior, these would qualify a truck or van as a non-personal use vehicle. The cost of such vehicle could be expensed up to the full limit and is not subject to the dollar limits applicable to passenger vehicles.

Standard Mileage Deduction

Self-employed taxpayers and certain employees (i.e., those who can still deduct their business expenses as other than miscellaneous itemized deductions subject to the 2% of AGI floor) who use their cars for business may, instead of computing their actual car expenses, take a flat deduction for each mile the car is used for business. The standard mileage rate for business use of a vehicle in 2019 is 58¢ per mile (it had been 54.5¢ per mile for 2018). This standard rate is in lieu of all expenses such as gasoline (including tax thereon), oil, repairs, license plates, insurance, and depreciation if the car is owned or lease payments if the car is leased. However, the following items are deductible in addition to the mileage rate:

Parking fees and tolls attributable to business use

Interest

State and local taxes incurred in purchasing the car Example Barbara Porter, a self-employed fitness coach, buys a new car on January 4, 2019, and drives it 36,000 miles a year for business (3,000 miles a month). Her actual costs for using the car for business are $20,000 a year. Her deduction under the standard mileage rate is $20,800 (36,000 miles x 58¢). Because the standard mileage rate provides the larger deduction, she uses the standard mileage rate in lieu of deducting actual costs.


Pitfall The standard mileage rate merely relieves taxpayers of having to record automobile expenses and substantiate them if the return is audited. It is still necessary to keep an accurate record of business mileage (including the miles, time, place, and business purpose for the travel). In many cases, the standard mileage rate provides a greater deduction than the taxpayer’s actual expenses, especially where mileage is high. However, in some instances the actual cost method produces a greater deduction. This is particularly true when a large proportion of an expensive car’s usage is for business purposes, but the total mileage is low.

Standard Mileage Rate Exclusions

The standard mileage rate may not be used in the following situations:

Modified Accelerated Cost Recovery System (MACRS) or first-year expensing was used for the car.

Claimed actual car expenses for a leased car.

Rural mail carriers who received a qualified reimbursement.

Five or more cars are used for business simultaneously (e.g., a fleet operation).

Changing Write-off Methods

A taxpayer may change from the standard mileage rate to the actual cost method. However, depreciation is then limited to straight line (provided the car has not already been fully depreciated). A taxpayer who has used the actual cost method and claimed first-year expensing or accelerated depreciation cannot change to the standard mileage rate for that car.

Rural Letter Carriers

Reimbursements by the U.S. Postal Service up to the carrier’s actual costs are not taxable to the carrier, nor deductible by the carrier. If reimbursements are less than the carrier’s actual costs, excess costs are not deductible in 2018 through


2025 because of the suspension of the miscellaneous itemized deductions subject to the 2%-of-AGI floor.

Deducting the Costs of a Leased Car

The expenses of using a leased car for business can be deducted using the standard mileage rate or the actual expense method. However, the depreciation deduction limits on “luxury cars” cannot be avoided by leasing rather than buying.

A taxpayer who leases a luxury vehicle (one valued at an inflation-adjusted amount of $50,000 for a car first leased in 2019) is limited to deductions that are “substantially equivalent” to the limits on depreciation deductions imposed on car owners.

Control over a lessee’s deductions is achieved by essentially adding an “inclusion amount” to the lessee’s gross income (in fact the inclusion amount is subtracted from the deductible lease cost). For employees who are permitted to deduct their business expenses in 2019, this is done directly in Section C of Part II of Form 2106, Employee Business Expenses. In effect, the inclusion amount offsets rental deductions when the actual expense method is used.

The inclusion amount is based on the fair market value of the car on the first day of the lease. This determines an inclusion amount shown on an IRS table. The amount is prorated for the number of days of the lease term included in the tax year. Finally, the prorated amount is multiplied by the percentage of business use by the taxpayer.

For vehicles first leased in 2019, below is a table of sample ranges of fair market value. For other fair market values, see. Rev. Proc. 2019-26, Table 4. For inclusion amounts for cars leased in prior years, see Appendix A of IRS Publication 463, Travel, Gift, and Car Expenses.


Sample Inclusion Amounts

FMV of Car Tax Year During Lease

Over Not Over 1st 2nd 3rd 4th 5th and Later

$50,000 $51,000 0 1 1 3 3

55,000 56,000 22 49 72 88 102

60,000 62,000 46 102 151 181 211

70,000 72,000 90 198 293 353 408

80,000 85,000 140 308 458 549 635

Study Question

The standard mileage rate for business use of a car in 2019 is:

14¢ per mile

20¢ per mile

54.55¢ per mile

58¢ per mile

Meals Expenses

The cost of entertaining customers (or prospective customers), employees, business associates, and so on has long been held to be an ordinary and necessary business expense. However, the cost of entertaining for business is not deductible.

Club Dues

Dues paid for membership in social, athletic, or sporting clubs (such as airline clubs) are not deductible. However, dues to professional (e.g., bar association), business (e.g., chamber of commerce), and civic (e.g., Rotary or Lions) organizations are deductible.


Business Meals

The deduction for meals is limited to 50% of cost. So business meals while traveling away from home on business are 50% deductible. The IRS has also clarified that meals in town can also be 50% deductible. This rule applies as long as all of the following conditions are met:

1. The expense is an ordinary and necessary expense for a trade or business; 2. The expense is not lavish or extravagant under the circumstances; 3. The taxpayer, or an employee of the taxpayer, is present at the furnishing

of the food or beverages; 4. The food and beverages are provided to a current or potential business

customer, client, consultant, or similar business contact; and

5. In the case of food and beverages provided during or at an entertainment activity, the food and beverages are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts, and the employer or an employee is present when the food and beverages are furnished (Notice 2018-76). For example, the cost of tickets for taking a customer to a ballgame are not deductible, but the food and drinks purchased there are deductible (subject to the 50% limit). The entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

The 50% limit also applies to:

Meals provided on the employer’s premises to more than half of the employees for the convenience of the employer

Meals provided occasionally to enable employees to work late, overtime, or on weekends

Office snacks provided to employees on the employer’s premises

Special Limit for Certain Workers

Employees and independent contractors whose hours are governed by Department of Transportation hours of service limitations (such as interstate truck drivers) can deduct 80% of their meal costs.


If you are a family daycare provider and provide meals or snacks to eligible children, deduct 100% of the cost using either your actual costs or the standard meal and snack rates. Exceptions to the 50% Limitation Rule

The 50% limit does not apply if any of the following exceptions apply:

An employer’s expenses for meals if treated by the employer as compensation to the employee on the employer’s tax return and as wages for withholding purposes

Expenses for meals includible in the gross income of the recipient, who is not an employee of the taxpayer, as compensation for services rendered or as a prize or award, and included by the taxpayer on Form 1099 issued to the recipient

Expenses for recreational, social, or similar activities (including facilities primarily for employees’ benefit) other than certain highly compensated employees

Expenses for meals, including using facilities, made available by the taxpayer to the general public, such as a free concert

Expenses for meals sold by the taxpayer in a bona fide transaction for adequate and full consideration

Business Gifts

The law limits deductions for business gifts to $25 per individual per year, the same limit that applied more than half a century ago. Any amount in excess of $25 given to one individual during a year is not deductible. Gifts made to an individual’s spouse will be considered as having been made to the individual, unless the spouse has a separate business connection with the individual making the gift (Code Sec. 274).

Exclusions

Advertising giveaways costing less than $4 and on which the donor’s name is permanently imprinted are not included in the $25 limitation. Also excluded from


the definition of “gifts” are signs, display racks, and other promotional materials to be used by the recipient on his or her business premises. An employer can exclude an employee achievement award from the employee’s income only if the employer can deduct the award. To be deductible, the award must be:

Made for length-of-service or safety achievement

Tangible personal property

Awarded as part of a meaningful presentation

Awarded under conditions and circumstances that do not create a significant likelihood of the payment of disguised compensation

Nonqualified and Qualified Plan Awards

Nonqualified Plan Award The total of all nonqualified plan awards made to any one employee during the tax year may not exceed $400. The total of all awards (including both qualified and nonqualified plan awards) made to any one employee during the tax year may not exceed $1,600. If the cost of the award is more than the amount the employer can deduct, the employer must include in the employee’s income the greater of:

1. The excess of cost over the employer’s allowable deduction 2. The amount by which the award’s value exceeds the employer’s allowable

deduction Qualified Plan Award A qualified plan award is one awarded as part of an established written plan by the employer that does not discriminate in favor of highly compensated employees. An award will not be considered a qualified plan award if the average cost of all employee achievement awards given by the employer during the tax year exceeds $400. In determining average cost, awards of very small value are not considered.


Study Question

To be deductible, a gift to a customer may not exceed:

$25 per year

$400 per year

$1,600 per year

Any reasonable amount

Substantiation of Travel Expenses

No deduction for travel, meals, or gifts is allowed unless the taxpayer can clearly substantiate by adequate records the amount, time, and place of travel, or date and description of the gift, and the business purpose of the travel or the business relationship to the taxpayer of each person receiving a gift. In the past, the most common method of meeting the “adequate record” requirement is by keeping a diary or account book in which all deductible expenses, together with the necessary explanatory details, are recorded at or near the time of the expenditure. Today, there are apps for this purpose. Each separate payment is usually considered a separate expenditure and must be separately recorded.

Recording of Expenditures

In recording various expenditures, such items as cab fares, phone calls, meals, gas and oil, and other incidental traveling expenses may be aggregated, and the daily total of each category listed in the taxpayer’s account book, diary, mobile tablet, or smartphone. For most items, notations in an account book, diary, or smartphone are sufficient. Documentary evidence, such as receipts, paid bills, or similar evidence, is not required for any expenditure (other than lodging) of less than $75. (Transportation charges for which documentary evidence is not readily available are exempted from this requirement.)


Planning Pointer Remember, the diary and documentary evidence should not be submitted with the return, but should be readily available if the return is questioned.

Per Diem Allowances

Where an employer reimburses an employee for automobile use at the standard mileage rate (58¢ per mile in 2019) or for travel using a per diem rate, substantiation requirements are simplified. Amounts reimbursed under a per diem arrangement are deemed substantiated when they do not exceed the applicable federal rate, which varies from locality to locality. The per diem rate can be used for lodging, meals, and incidental expenses or for meals and incidental expenses with separate reimbursement for actual lodging costs. Instead of using the federal per diem rate for lodging, meals, and incidental expenses in a particular locality, there is an even simpler option for travel within the continental United States.

High-low Method

Under a so-called “high-low” method, several high-cost areas (such as New York, Los Angeles, Washington, D.C., Atlanta, Chicago, Boston, and Philadelphia) have a per diem rate for travel on or after October 1, 2018, through September 30, 2019, of $287; all other areas within the continental U.S. are assigned a low per diem rate of $195 (Notice 2018-77). The meals and incidental expenses (M&IE) rate for high-cost areas is $68 ($57 for all other areas). (The rates for high-cost areas starting October 1, 2019, are $287; all other areas within the continental U.S. are assigned a low per diem rate of $195 (Notice 2018-77).) ED: Should have these missing figures at the end of September. The meals and incidental expenses (M&IE) rate for high-cost areas is $68 ($57 for all other areas). (The rates for high-cost areas starting October 1, 2018, are $287; all other areas within the continental U.S. are assigned a low per diem rate of $195 (Notice 2018-77).


Incidental expenses include only fees and tips to porters, baggage carriers, bellhops, hotel maids, stewards and stewardesses. However, if no expenses for meals are incurred, incidental expenses can be separately substantiated by a per diem rate of $5.

Study Question

The maximum dollar limit for depreciation claimed on a 2019 return for a vehicle bought and placed in service in 2019 and used 100% for business (and there is no election out of bonus depreciation) is:

$10,000

$14,900

$18,100

$25,500

Self-employed Persons Self-employed individuals deduct business expenses from gross income. Specifically, such expenses are entered directly on Schedule C and offset self-employment income.

Statutory Employees

Certain individuals may be treated as statutory employees whose business expenses are deductible without regard to the 2% floor, and so can deduct expenses in 2019 (Reg. §31.3121(d)(1)). Statutory employees are those who are treated as employees for FICA tax purposes but who are not traditional common-law employees. They include:

Full-time life insurance salespersons whose entire or principal activity is devoted to the solicitation of life insurance, annuity contracts, or both, primarily for one life insurance company

Agent-driver or commission driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and


delivers laundry or dry cleaning, if the driver the agent of the sole proprietor or is paid on commission.

Home workers. (An aerospace engineer who did consulting work was treated as a home worker because he performed work according to specifications furnished by the company and performed on materials required to be returned to the company [Fiedziuszko, TC Memo 2018-75]).

Traveling or city salespersons who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments.

A sole proprietor must withhold FICA taxes from the wages of statutory employees if:

1. The service contract states or implies that substantially all the services are to be performed personally by them.

2. They don't have a substantial investment in the equipment and property used to perform the services (other than an investment in facilities for transportation, such as a car or truck), and

3. The services are performed on a continuing basis for the same payer. Individuals need not make the determination of whether they are statutory employees. Statutory employee status is reflected on Form W-2, on which their wages for the year are reported. Statutory employees list their business expenses on Schedule C.

Employees

Unreimbursed employees’ business expenses are miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor and, as such, are not deductible in 2018 through 2025.

Investment Expenses

Code Sec. 212 allows taxpayers to deduct expenses “incurred for the management, conservation, or maintenance of property held for the production of income.”


Generally, investment expenses, such as investment counsel fees, the cost of safe deposit fees to hold securities, state and local transfer taxes, collection charges and commissions, cost of secretarial services, telephone, and postage, are treated as miscellaneous itemized deductions subject to the 2%-of-AGI floor. As such, they are not deductible in 2018 through 2025.

However, expenses attributable to property held for production of rents or royalties that are deductible from gross income as “above-the-line” deductions on Schedule E.

Home Office Expenses

A deduction for the business use of a personal residence is allowed only if the space is used exclusively and on a regular basis as any of the following (Code Sec. 280A):

The principal place of any business in which the taxpayer engages. A home is treated as a principal place of business if it is used for substantial administrative or managerial activities and there is no other fixed location for the performance of these activities.

A place of business used for meeting clients, customers, or patients.

In connection with the taxpayer’s trade or business if the taxpayer is using a separate structure that is not attached to the dwelling.

If the space is in a separate building, not attached to the taxpayer’s residence, it will qualify so long as it is used exclusively and on a regular basis for business purposes. Business expenses related to space in a home used regularly (even if not exclusively) as a storage unit for inventory or sample items (or both) are deductible if the home is the sole fixed location of the business.

Exceptions to Exclusive Use Test

One exception to the exclusive use test is if the residence is the only fixed location of a trade or business engaged in selling products at retail or wholesale, provided a separate, identifiable portion of the residence is regularly used for inventory storage. Thus, where a part of a basement is used for this purpose, the


proportionate part of the expenses will qualify, even though the basement is used for other purposes as well. Another exception is where a residence is used to provide day care services to children, handicapped individuals, and the elderly on a regular basis.

Home Office Deduction

There are two ways in which to figure the home office deduction:

The actual expense method

A simplified method Actual Expense Method This method requires eligible individuals to take into account all of the expenses related to the home (other than those that are not permitted). The home office deduction by Schedule C filers is first figured on Form 8829, Expenses for Business Use of Your Home, and then entered on Schedule C. Farmers and partners figure their home office deduction on a worksheet modeled after Form 8829. Simplified Method Those who are eligible for a home office deduction can opt to figure it by multiplying the square footage (up to 300 square feet) by $5. For example, if the space is 300 square feet or more, the top deduction is $1,500. Figure the deduction on the worksheet for this purpose in the instructions to Schedule C. No depreciation is allowed if this method is used. Form 8829, discussed above, need not be completed.

Planning Pointer and Example Planning Pointer The election to use the simplified method can be made on a year-by-year basis. There is no basis adjustment to the home for depreciation in any year in which the election is made.


Form 8829 consists of four parts. Part I is used for figuring the portion of the home used for business. Generally, this is figured by dividing the area used for business by the total area in the home to arrive at a “business percentage.” Example Sue Brandt uses 500 sq. ft. of her 2,000-sq.-ft. house as a home office. Her business percentage is 25% (500 sq. ft. ÷ 2,000 sq. ft.). The allocation, however, can be based on the number of rooms if the rooms are all of approximately equal size. Part II of Form 8829, Expenses for Business Use of Your Home, is used for figuring allowable deductions. The form distinguishes between direct and indirect expenses.

Direct and Indirect Expenses

Direct Expenses Direct expenses are those solely connected with a home office. No deduction, direct or indirect, is allowed for the cost of landscaping the home. Indirect Expenses Indirect expenses are first listed and then the percentage of business use is applied to arrive at the deductible portion. Indirect expenses are those applicable to the entire residence, such as mortgage interest on a loan for the entire residence and real property taxes. Depreciation is figured in Part III of Form 8829. Again, it is figured on the business portion of the home. Usually, a home office is treated as nonresidential realty, with a 39-year recovery period.

Pitfall Any depreciation taken on a home office after May 6, 1997, is “recaptured” as ordinary income at the rate of 25%. However, the home sale exclusion can be claimed for the home office portion as long as the office is part of the dwelling unit (no allocation of gain is required for the business portion of the home).


Gross Income Limit

The deduction for home office expenses is limited to the gross income from the business use of the homeless the sum of:

1. Business percentage of personal deductions (mortgage interest, real estate taxes, and casualty losses in federally-declared disaster areas)

2. Business expenses other than those related to the business use of a home

Therefore, the deduction is limited to modified net income from the business use of a home, that is, the net income of the business without including the home expenses (other than the business percentage of mortgage interest, real estate taxes, and certain casualty losses). Thus, a deduction for the business use of a home will not create a business loss or increase a net loss from a business. The gross income limitation is built into Part III of Form 8829. Due to the itemized deduction limit on state and local taxes, it is essential to determine the extent to which real estate taxes are or are not subject to the gross income limit (see Program Manager Technical Advice 2019-001). Disallowed home office deductions can be carried forward to later years, subject to the income limitations in those years from the business activity. The carryover of disallowed expenses to 2020 is figured in Part IV of Form 8829.

Example Bob Brown operates a retail sales business from his home. He uses 20% of his home for this business and figures his home office deduction using the actual expense method. In 2019, his gross income, expenses for the business, and computation of the deduction for the business use of his home are as follows.

Gross income $12,000

Less Inventory, supplies, etc. 9,000

Business percentage of mortgage interest and real estate taxes

2,000

Total Direct expenses 11,000

Modified net income-deduction limit $1,000

Business use of home expenses-indirect expenses


Maintenance, insurance, utilities (20%) $800

Depreciation (20%) 1,600

Total $2,400

Deduction limited to modified net income 1,000

Carryover expenses to 2020 (subject to income limitation in 2020)

$1,400

No business deduction (other than itemized deductions such as real estate taxes and mortgage interest) is allowed for a home office leased to an employer.

Home Office Telephone

The cost of basic charges of a first landline in a home is not deductible. Other charges, such as long distance calls, call waiting, and equipment rentals, are deductible.

Study Question

Which indirect expense related to a home is not part of a home office deduction?

Mortgage interest

Landscaping

Real estate taxes

Utilities

Educational Expenses

Taxpayers may deduct educational expenses (Code Sec. 162), such as the cost of special training programs or courses (including correspondence courses and research activities) undertaken for the purpose of either:

Maintaining or improving skills required in the taxpayer’s present trade or business


Meeting the requirements of the taxpayer’s present employer as a condition of present employment or salary (although employees cannot deduct their education costs in 2018 through 2025)

Deductible Expenses

Deductible expenses include tuition, books, and other supplies as well as the cost of travel, board, and lodging, if the training is away from home. Planning Pointer Instead of deducting education expenses, a taxpayer may qualify for education tax credits. The credit may produce a greater tax benefit than the deduction. Whether or not the education meets the above requirements depends on the facts of each case. Thus, if it is customary for other individuals in the taxpayer’s trade, business, or profession to undertake such education, the expenses would ordinarily be deductible. Example John Blalock, a tax practitioner, annually takes a brush-up course to review new tax developments and refresh his tax knowledge. His expenses are deductible because the training is undertaken to maintain or improve skills required in his trade or business. However, a deduction for educational expenses is not permitted if the education or training qualifies (or helps qualify) the taxpayer for a new trade or business. Example Bernard Robinson, a self-employed psychiatrist, undertakes a program of study and training as a psychoanalyst at a psychoanalytic institute. The course will enable him to qualify as a practicing psychoanalyst. His expenditures are deductible because his study and training maintain or improve skills required for his profession and do not qualify him for a new trade or business.


For Persons Engaged in a Trade or Business

For persons engaged in a trade or business, the allowable education expenses are deducted from gross income, along with all other business expenses as adjustments to gross income. Education expenses of an employee are considered miscellaneous deductions subject to the 2%-of-adjusted-gross-income rule, which are not deductible in 2018 through 2025. However, if the taxpayer’s AGI is below a set limit, higher education tuition and fees up to $4,000 are deductible as an above-the-line deduction whether or not job-related (tuition and fees deduction) (if the deduction that expired at the end of 2017 is extended to 2019). Planning Pointer A taxpayer may be eligible for a lifetime learning education credit for higher education courses if modified adjusted gross income is below set limits, which are less than the limits for the above-the-line deduction for tuition and fees. Depreciation Taxpayers who acquire machinery, equipment, trucks, office furniture, buildings, or other property used in a trade, business, or real estate investment activities can recover the cost over a period of time by means of tax deductions (depreciation)(Code Secs. 167 and 168). Depreciation is viewed as a deduction for the wear and tear on property. Thus, antiques generally are not depreciable (although two musicians convinced courts that their antique instruments were depreciable because they were subject to wear and tear—Simon, CA-2, 95-2 USTC ¶50,552; Liddle, CA-3, 95-2 USTC ¶50,488). Because land is not subject to the same wear and tear as other property, it generally is not depreciable.

Depreciation Deduction To be eligible for a depreciation deduction, the property must be used in the taxpayer’s trade or business or be held for the production of income. No depreciation may be taken on a taxpayer’s private residence, pleasure


automobile, home furnishings, and so on. Also, no depreciation allowance may be taken on property held primarily for sale to customers, such as stock in trade and merchandise inventory. If property is used for both business and personal purposes, only that part of the depreciation allocable to business use may be deducted. Example Frank Conner owns a two-family house; he resides in one apartment and rents the other. Depreciation is allowed on the portion rented, usually based on the number of rooms.

Depreciation Deduction Certain property used only partly for business will be affected by the “mixed-use” rule. This involves passenger cars and other so-called listed property.

1. There are various methods to use in claiming depreciation. 2. The appropriate method depends on the type of asset involved (e.g.,

machinery or real estate) and when the asset is first used in the business or income-producing activity.

3. This time is referred to as the date the asset is “placed in service.” It is not the date on which the asset was purchased, but rather the date it was put to use.

MACRS Assets placed in service in 2019 generally are depreciated under the Modified Accelerated Cost Recovery System (MACRS). This method applies to property placed in service after December 31, 1986, and to property placed in service after July 31, 1986, for which an election was made to have MACRS apply.

Reporting Depreciation According to instructions to Form 4562, it need not be filed by individuals if no new property is placed in service in 2019, no amortization is being claimed, and no depreciation is being claimed on a vehicle placed in service in a prior year.


Simply figure the depreciation and enter the amount on the appropriate form or schedule. Self-employed persons can use Part IV of Schedule C to figure depreciation on a business car or truck if they are not otherwise required to file Form 4562. Employees who are eligible to claim depreciation on cars (e.g., employees with impairment-related work expenses) must complete Form 2106, Employee Business Expenses.

Failure to Take Depreciation Taxpayers should claim the proper amount of the allowed or allowable depreciation deduction for each year of eligibility (Code Sec. 1016). This includes the bonus depreciation allowance, where applicable, unless the taxpayer elects not to deduct it. Pitfall If taxpayers fail to deduct the allowable amount in one year, they may not generally deduct the unclaimed depreciation in a later year (except on an amended return). Still, the unclaimed depreciation (the amount that had been allowed) reduces the basis of the property for purposes of determining gain or loss on a disposition.

Basis for Determining Depreciation

Generally, the basis for depreciation is the same as that used for determining gain if the property is sold. For this purpose, the basis is usually the property’s cost increased by improvements and decreased by any depreciation previously deducted (Code Secs. 167 and 168). Under MACRS, the property’s unrecovered basis is used (that is, generally the cost or other basis adjusted for depreciation previously allowed or allowable and for all other applicable adjustments).


Examples Example If a nonbusiness asset is converted to business use, depreciation is allowable from the date of its conversion, and its basis is the lower of the fair market value or the adjusted basis. Example In 2009, John Grey purchased as his residence a single-family home for $271,000, of which $10,000 represented the cost of the land. In 2010, he finished his basement, at a cost of $1,500. On July 1, 2019, he vacated the house and began renting it. The fair market value of the house in July 2019 was $365,000 (excluding the land). John’s basis for computing depreciation is $262,500, the adjusted basis at the time of the conversion, because it is less than fair market value. Land is not depreciable for tax purposes. Remember that depreciation is computed on the full cost or other basis of the property (other than land), even if the property is mortgaged or subject to other indebtedness. Example Assume that John, in the previous example, had invested only $8,500 in his property, the balance being secured by a mortgage. He is still entitled to a depreciation deduction on the entire $262,500.

Classes of Property

Under MACRS, the classes of property are 3-, 5-, 7-, 10-, 15-, 20, and 25-year property. Different classes apply to Indian reservation property. In addition, most real property is classified as residential rental or nonresidential real property which is depreciated over 27.5 and 39 years respectively. Planning Pointer


MACRS is not used for certain property. For example, the income forecast method is used for film, videotape, sound recordings, copyrights, books, patents, and other similar property. However, the income forecast method cannot be used for consumer durables subject to rent-to-own contracts. The class to which property is assigned is determined by its class life. The class life of an item of property determines its recovery period, the method of depreciation used, and the applicable convention. (Declining balance, straight-line, and other depreciation methods are defined later in this course.)

Classes of Property under MACRS

Under MACRS, property other than residential rental or nonresidential real property will fall into one of the following classes:

3-year property This class includes property with a class life of 4 years or less, such as tractor units for use over the road, breeding hogs, and, as designated, any race horse that is over 2 years old when placed in service and any other horse that is over 12 years old when placed in service. This class also includes rent-to-own property placed in service after August 5, 1997. Computer software generally is 3-year property unless it has a shorter life (e.g., it is the type that is replaced each year).

5-year property This class includes property with a class life of more than 4 years but less than 10 years, such as breeding sheep and goats; breeding and dairy cattle; most farming equipment; heavy, general-purpose trucks, computers and peripheral equipment; office machinery (fax machines, calculators, and typewriters); carpet, appliances, and furniture used in residential rental realty; qualified technological equipment; any property used in research and experimentation, certain geothermal, solar, and wind energy property, and, as designated, any auto or light, general-purpose truck.

7-year property This class includes property with a class life of 10 years or more but less than 16 years; office furniture (e.g., desks, files, and safes) and fixtures; breeding and work horses 12 years old or less when placed in service;


railroad track; used agricultural machinery and equipment placed in service after 2017; grain bins, cotton ginning assets, or fences used in a farming business; and, as designated, any single-purpose agricultural or horticultural structure. This class also includes any property that does not have a class life and that has not been designated by through 2017, motorsport racing complexes were 7-year property; this recovery period could be extended for 2019.

10-year property This class includes property with a class life of 16 years or more but less than 20 years. This includes vessels, barges, tugs, and similar water transportation equipment, assets used for petroleum refining or for the manufacture of grain and grain mill products, sugar and sugar products, or vegetable oils and vegetable oil products, and single-purpose agricultural or horticultural structures.

15-year property This class includes property with a class life of 20 years or more but less than 25 years. It includes certain land improvements (eg., shrubbery, fences, sidewalks) and assets used in the manufacture of cement.

20-year property This class includes property with a class life of 25 years or more, such as farm buildings except single-purpose agricultural and horticultural structures, and railroad hydraulic and nuclear electric generating equipment.

25-year property This class includes water utility property.

Indian reservation property Property placed in service after 1993 used predominantly in the active conduct of a trade or business on an Indian reservation (for purposes other than gaming) has special recovery periods for property placed in service before January 1, 2018 (unless this recovery period is extended)(Code Sec. 168(j)(9)).

For property in the 3-, 5-, 7-, or 10-year class, the 200% declining balance method over 3, 5, 7, or 10 years and a half-year convention is used. For property in the 15- or 20-year class, the 150% declining balance method over 15 or 20 years and


a half-year convention is used. For 3-, 5-, 7-, or 10-year property used in a farming business and placed in service after 2017, in tax years ending after 2017, the 150% declining balance method is no longer required. However, the 150% declining balance method continues to apply to any 15- or 20-year property used in a farming business to which the straight line method does not apply or to property for which an election to use of the 150% declining balance method is made. The applicable depreciation rate (in percentage terms) is determined by dividing the specified declining balance percentage (150% or 200%) by the applicable recovery period. This applicable depreciation rate is constant for each tax year in which the declining balance method is used and is applied to the property’s unrecovered basis (that is, generally, the cost or other basis adjusted for depreciation previously allowed or allowable and for all other applicable adjustments). The 200% declining balance method applied to property with a 5-year recovery period results in an applicable depreciation rate of 40%(200 ÷ 5) in each full tax year. The 150% declining balance method applied to property with a 7-year recovery period results in a depreciation rate of 21. 43% (150 ÷ 7) in each full tax year. The tables automatically change to the straight-line method for the first tax year in which use of the straight-line method yields an allowance equal to or greater than the allowance yielded by using the declining balance method. Also, the taxpayer must use the straight-line method for nonresidential real property, residential rental property, and any other class of property for which the taxpayer elects to use it. For all classes, salvage value is treated as zero. Planning Pointer Recovery periods for MACRS assets as well as depreciation tables are in IRS Publication 946, How to Depreciate Property.


Classes of Property under MACRS

Under MACRS, the half-year convention treats all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, on the midpoint of that tax year. Thus, as a practical matter, 5-year property will be depreciated over a period of 6 years.

Half-year Convention

(mentioned above) The following example is based on depreciation rates found in Table A-1 of IRS Publication 946 (2015). Example On February 1, 2019, David Greenwood placed in service a machine costing $10,000; it has a 5-year recovery period. (Assume he does not elect the Sec. 179 deduction and opts out of bonus depreciation.) His allowances are as follows:

2019 $2,000 (20% of $10,000)

2020 $3,200 (32% of $10,000)

2021 $1,920 (19. 2% of $10,000)

2022 $1,152 (11. 52% of $10,000)

2023 $1,152 (11. 52% of $10,000)

2024 $576 (5. 76% of $10,000)

Optional Tables

Optional tables can be used by certain taxpayers in computing annual depreciation allowances. These tables specify schedules of annual depreciation rates to be applied to the property’s unadjusted basis in each tax year. If a taxpayer uses a table to compute the annual allowance for any item of property, the taxpayer must use the table to compute the annual depreciation allowances for the entire recovery period of such property.


However, a taxpayer may not continue to use the table if there are any adjustments to the property’s basis for reasons other than:

1. Depreciation allowed or allowable 2. An addition or an improvement to such property that is subject to

depreciation as a separate item of property Taxpayers use the appropriate table for any property based on the depreciation system, the applicable depreciation method, the applicable recovery period, and the applicable convention. The tables list the percentage depreciation rates to be applied to the property’s unadjusted basis in each tax year. If, during any tax year, the aggregate bases of MACRS property that is placed in service during the last 3 months of that tax year exceed 40% of the aggregate bases of all property placed in service during that tax year, a mid-quarter convention is used instead of a half-year convention. In determining the aggregate bases of MACRS property, the following property is not taken into account:

Residential rental or nonresidential property Property depreciated under another method pursuant to an election (e.g.,

unit of production method or other method not expressed in a term of years other than the retirement-replacement-betterment method or similar method)

Public utility property Films and videotapes Sound recordings Property placed in service for the purpose of securing accelerated

depreciation (i.e., property placed in service in churning transactions) Short-term property (property placed in service and disposed of within the

same year)

Property Placed in Service The term “placed in service” means “first placed in a condition or state of readiness and availability for a specifically assigned function” (Reg. §1.167(a)-11(e)(1)(i)). In one case, a court said a building was placed in service when it obtained a certificate of occupancy even though it was not open for business (Stine, LLC, DC LA, 2015-1 USTC ¶50,172).


In a mid-quarter convention, all property placed in service, or disposed of, during any quarter of a tax year is treated as placed in service, or disposed of, at the quarter’s midpoint. Property placed in service and disposed of within the same tax year is disregarded in making the 40% determination. See Tables A-2 through A-5 of IRS Publication 946 (2019).

Real Property

Residential Real Property Residential real property is depreciated over 27.5 years using the straight-line method and a mid-month convention. Nonresidential Real property Nonresidential (commercial) property is depreciated over 39 years using the straight-line method and a mid-month convention. Nonresidential real property used predominantly in the active conduct of a trade or business on an Indian reservation (for other than gaming purposes) has a 22-year recovery period. Note Indian reservation property placed in service prior to 2017 had a special recovery period (Code Sec. 168(j)); this rule may be extended for 2019. Qualified Improvement Property Improvements to qualified improvement property can enjoy special tax treatment. It qualified for:

Sec. 179 deduction

Bonus depreciation

15-year recovery period, assuming a technical correction is made. If not it is 39-year property.

“Qualified improvement property” means an improvement to the interior portion of a building that is nonresidential real property and which has already been placed in service. It does not include any enlargement to the building, an elevator


or escalator, or changes to the internal structure of the building. The previous categories of qualified leasehold improvements, qualified retail improvements, and qualified restaurant improvements no longer apply. Qualified Real Property Qualified real property eligible for the Section 179 deduction includes:

Roofs

Heating, ventilation, and air-conditioning property

Fire protection and alarm systems

Security systems Commercial Buildings Commercial buildings that achieved a 50% energy savings target can deduct $1.80 per square foot of building floor area (60¢ per square foot for more modest energy savings)before 2018 (Code Sec. 179D); this provision may be extended for 2019. If so, then before claiming the deduction, the owner must obtain certification that the required energy savings will be achieved. Planning Pointer Property acquired in a like-kind exchange can be depreciated over the remaining recovery period of the old property. For example, if there were 12 years remaining on the recovery period of the old building, the newly acquired building can be depreciated over those 12 years.

Planning Pointer When a taxpayer makes a substantial improvement to a building, it is treated as a separate building rather than as one or more components.

Mid-Month Convention

Under a mid-month convention, all property placed in service, or disposed of, during any month is treated as placed in service, or disposed of, on the midpoint of that month. See Tables A-6 through A-8 of IRS Publication 946 (2019).


Section 179 Deduction Taxpayers can elect to treat a qualifying property’s cost, up to a limited amount, as a current expense. (Special dollar limits discussed earlier apply to vehicles.) This is called first-year expensing or the Sec. 179 deduction. The basic dollar limit for expensing in 2019 is $1,020,000. The dollar limit begins to phase out when equipment purchases for the year exceed a set dollar limit ($2.55 million in 2019). The deduction allowed for a taxable year cannot exceed the taxpayer’s business income for the year. The costs for which the election is made are allowed as a deduction for the tax year in which the qualifying property is placed in service and are deducted currently instead of employing a MACRS deduction. The costs are expensed under Code Sec. 179.

Qualifying Property

Qualifying property includes:

Tangible personal property that is recovery property

Off-the-shelf computer software

Qualified improvement property

Qualified improvements to nonresidential property (roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems)

Films, television, and live theatrical productions

Property used on connection with the furnishing of lodging

Expenses Not Allowed

Expensing is not allowed for:

1. Property acquired from a related party 2. Property acquired by a component member of a controlled group from

another member of the same group 3. Property held for lease to others 4. Autos on which the standard mileage rate is used


5. Property the basis of which is determined in whole or in part (a) by reference to the transferor’s adjusted basis or (b) under the stepped-up basis rules for property acquired from a decedent

Taxable Income Limitation

An additional limitation is imposed on first-year expensing. The amount allowed as an expense deduction cannot exceed taxable income derived from the active conduct of a trade or business. However, any deduction disallowed as a result of this limitation can be carried forward and deducted in a subsequent year (assuming there is sufficient taxable income in that year). For a partnership and an S corporation, both the entity and each owner are subject to the annual dollar limitation, as well as the taxable income limitation.

Recapture of Expensing

The expensing deduction is recaptured when property is not predominantly used in a trade or business at any time before the end of the recovery period. Thus, in the tax year that the property is not used predominantly in a trade or business, the taxpayer must include in income the “tax benefit” derived from the expensing deduction.

Electing Expensing

A taxpayer makes an election to expense property under Code Sec. 179 on Part I of Form 4562 and must specify the items of property to which the election applies and the part of the cost of each of these items to be deducted currently. The election must be made on an original return (including a late-filed original return) or an amended return for the year that the property is placed in service.

An election can be revoked without IRS consent. The change is made by filing an amended return, but once this is done, it cannot be changed again without IRS consent.


Bonus Depreciation

There is an additional first-year depreciation allowance of 100% of the adjusted basis of qualified property that can be claimed for qualified property placed in service in 2019. This allowance is called bonus depreciation; it is also referred to as a first-year depreciation allowance. Bonus depreciation applies in addition to any Section 179 deduction that may be claimed, although the basis of the property is first reduced by the expensing deduction before figuring bonus depreciation. Bonus depreciation is not taken into account in determining the basis of property for purposes of the mid-quarter convention. In effect, the basis of property placed in service in the last quarter of the year is determined without regard to bonus depreciation.

Eligible Property

Bonus depreciation applies to any tangible personal property with a recovery period of 20 years or less, computer software (other than a Code Sec. 197 intangible), and qualified improvement property. It also applies to films, television shows, and theatrical productions as well as for specified plants that are planted or grafted in 2019. Property subject to floor plan financing, such as certain motor vehicles, boats, farm machinery, and lease businesses, are excluded from bonus depreciation.

Election Out of Bonus Depreciation

Unlike regular depreciation that effectively must be claimed (it reduces the property's basis whether or not a deduction is taken), a taxpayer may opt out of using bonus depreciation. If no election is made in Part II of Form 4562, then bonus depreciation automatically applies to all eligible property. If an election is desired, it must be made on a per-asset class basis.


Planning Pointer Consider opting out of using bonus depreciation if the taxpayer’s business has little or no current business income against which to use the write-off but expects to have higher income in future years.

Alternative Depreciation System (ADS)

Instead of claiming accelerated depreciation over the applicable recovery period for personal property and the applicable recovery period for real property, different recovery periods (and methods) can be used under the alternative depreciation system (ADS). For example, an election can be made to depreciate equipment over its applicable recovery period using the straight-line method instead of accelerated depreciation. Real property and farming businesses that elect out of the limit on deducting business interest under Code Sec. 163(j) must use ADS to depreciate nonresidential property, residential property, and qualified improvement property. For real property (both residential and nonresidential), an election can be made to use a 30-year recovery period.

Limits on Depreciation for Mixed-use Property

Limits are placed on the depreciation deductions allowed for cars and other “listed property” (Code Sec. 280F). Cellular phones and computers are no longer listed property.

Property Not Predominantly Used in Business

“Listed property” not used more than 50% in qualified business use is limited to depreciation on a straight-line basis over the ADS recovery period. These recovery periods can be found in Table B-1 of IRS Publication 946, How to


Depreciate Property. For example, office furniture and fixtures, which has a 7-year recovery period under MACRA, has a 10-year recovery period under ADS.

Investment-Related Use

Where business use exceeds 50%, then investment-related use can be added to arrive at a final percentage. This is the percentage of the otherwise allowable deduction that can be claimed for listed property. For example, if business use of a car is 80% and the deduction otherwise allowable for such car is $1,000, the deduction is limited to $800. All taxpayers claiming either a depreciation allowance or lease payment deduction for autos or other listed property, regardless of the tax year in which this property was placed in service, must provide certain information to the IRS. Form 4562 is used for this purpose, regardless of the year in which the property was placed in service. Special dollar limits restrict write-offs for so-called luxury cars used for business, as explained earlier in this course.

Change of Depreciation Methods

Taxpayers may use different depreciation methods for different assets; thus, they may use the straight-line method for one asset or group of assets, and the declining balance method for other assets. However, once they have begun to use a particular depreciation method for any asset or assets, they cannot change to another method without obtaining prior IRS approval. An exception to this rule is that, if taxpayers are using the declining balance method, they may change to the straight-line method at any time without obtaining prior approval.


IRS Procedures

The IRS has procedures under which a number of changes in depreciation method can be made—with approval considered to have been given—if specified rules are followed. File Form 3115, Application for Change in Accounting Method, with the Service Center where the taxpayer filed his or her return during the year of change. Approval is automatic if the taxpayer files on time and furnishes all of the information required (refer to IRS Publication 538, Accounting Periods and Methods, for details). Planning Pointer The IRS provided a simplified procedure for obtaining automatic consent to change an accounting method to claim under-depreciation when the taxpayer still owns the property. No user fee is required (Rev. Proc. 2008-52, which has been updated over the years, most recently in Rev. Proc. 2018-31). Check the applicable codes listed for the automatic consent to a change in accounting method.

Depreciation Recapture

When certain property is sold, then some or all of depreciation claimed may have to be “recaptured” under Code Sec.1245 or 1250. The effect of the recapture provision is to treat the gain (or that part of it) that resulted from the depreciation deduction as ordinary income, rather than as a capital gain. Depreciation recapture is reported in Part III of Form 4797, Sales of Business Property.

Depreciation Recapture on Personal Property

Under Code Sec. 1245, any gain on the sale or exchange of depreciable personal property is treated as ordinary income (instead of as a Code Sec. 1231 gain) to the extent of depreciation deducted (called Section 1245 gain). The remainder of the gain, if any, is treated as Section 1231 gain, and thus may qualify for capital gain treatment.


Examples Example Ralph Collins installed equipment on January 5, 2013, for $5,600. On January 5, 2019, when the adjusted basis of the equipment was $3,528 ($5,600 less $2,072 depreciation), he sold it for $6,400, resulting in a realized gain of $2,872. Recapturable depreciation is $2,072. A portion of this gain is Section 1245 income, computed as follows:

Amount realized from sale $6,400

Adjusted basis 3,528

Realized gain $2,872

Ordinary income (Code Sec. 1245) $2,072

Eligible for capital gain (Code Sec. 1231) $800

In the example above, the Section 1245 income is equal to the total depreciation deducted. Obviously, if the selling price produced a gain less than the depreciation, the Section 1245 income will be limited to the actual gain. Example Assume that, in the above example, Ralph had sold the machine for $5,600 (instead of $6,400), resulting in a realized gain of $2,072. The entire gain is Section 1245 ordinary income. If a taxpayer transfers Code Sec. 1245 property to another person by gift and the recipient later sells the property at a gain, the donee must take into account any depreciation deducted by the donor in computing his Section 1245 income. Example Aaron Small purchased Section 1245 property on January 1, 2017, for $10,000. Aaron claimed depreciation deductions of $2,000 before gifting the property to his son, Ben. Under the rules previously discussed, Ben’s adjusted basis in the property is $8,000, the same as in his father’s hands.

Assume further that Ben claims another $1,000 depreciation on the property (reducing his adjusted basis to $7,000) and then sells it for $10,500, realizing a gain of $3,500. Of the gain, $3,000 would be treated as Section 1245 ordinary income. The remainder of the gain, $500, is treated as a Section 1231 gain.


A conversion of business property to personal use is treated as a disposition, but no depreciation recapture is recognized on the conversion.

Section 1245 Recovery Property

A first-year expense deduction is treated as a depreciated deduction for purposes of Section 1245 depreciation recapture. Thus, if property that was expensed ceases to be predominantly used in a trade or business (more than 50% business use), then recapture results. If property that was expensed is sold through the installment method, the expense deduction is subject to immediate recapture.

Depreciation Recapture

Any “depreciation recapture property” that was used more than 50% in a trade or business in the year it was placed in service, but in the current tax year is used 50% or less, is subject to depreciation recapture. If taxpayers contribute property to a qualifying charitable organization, they are generally entitled to a deduction (from adjusted gross income) equal to the fair market value of the contributed property, subject to applicable limitations. However, if the contributed property consists of Section 1245 property, the contribution deduction must be reduced by the amount that would have been treated as Section 1245 gain if the property had been sold at its fair market value instead of contributed to the charity. Example Dennis Rudolph donates depreciable property to a charity with an adjusted basis of $10,000 and a fair market value of $17,000. Depreciation was $4,000. If Dennis had sold the property for $17,000, he would have had a Section 1245 gain of $4,000. Hence, the amount of the contribution deduction would be limited to $13,000 ($17,000 – $4,000).


Depreciation Recapture on Real Estate

There are two different sets of rules for figuring depreciation recapture on real estate (Code Sec. 1250). All of the depreciation taken on residential real property attributable to periods after 1975, including straight-line, is recaptured if the property is disposed of within 12 months. Under MACRS, there is no recapture for all residential rental or nonresidential real property, since they are subject to straight-line depreciation. However, on sales of such property on or after May 7, 1997, there may be “unrecaptured depreciation.” This is the total of all depreciation taken on such property not otherwise recaptured as ordinary income, and it is taxed at a maximum rate of 25% if the balance of the gain is subject to the 15% (or 20%) capital gains tax rate. The amount of gain representing unrecaptured depreciation is treated as reported first and subject to the 25% tax rate. Once all such unrecaptured depreciation has been reported, further gain is taxed at the 15% rate (20% rate for with taxable income over a threshold amount). Example Property purchased for $100,000 is sold on the installment method for $130,000 in five equal annual installments. The property had been depreciated to $80,000, resulting in a gain on the sale of $50,000 ($130,000 amount realized less $80,000 basis).

The gain represents $20,000 depreciation recapture, plus $30,000 long-term capital gain. Of each payment of $26,000, $10,000 represents gain and $16,000 represents return of basis. So gain in the first two payments is taxed at 25% (representing a total of $20,000 Section 1250 gain), while gain on the final three payments is taxed at 15% (assuming the taxpayer is not subject to the 20% rate on capital gains).

Study Question

Unrecaptured depreciation means that all depreciation claimed after May 6, 1997, is taxed at a 25% rate when property is disposed of (assuming the taxpayer is in a tax bracket at or above this rate).


True

False

Amortization

The deduction for amortization is similar to depreciation in that the taxpayer is permitted to write off, or “amortize,” certain expenses over a given period of time. Unlike depreciation, amortization is always computed on a straight-line basis. Amortization, like depreciation, is deductible from gross income in computing adjusted gross income. Form 4562, Depreciation and Amortization, is used to report amortization deductions.

Cost of Acquiring a Lease

When a taxpayer incurs expenses in acquiring a lease on business or income-producing property, that cost may be amortized over the period or remaining period of the lease. For property placed in service after 1986, the term of a lease is determined by including all renewal options as well as any other period for which the parties reasonably expect the lease to be renewed. Example Ellen Hughes paid a previous tenant $10,000 for transferring to her the lease in a desirable office building. The remaining unexpired period of the lease was 5 years, and the lease contained a 5-year renewal clause. Obviously, part of the amount paid for the lease was for its unexpired portion, and part was for the option to renew the lease. If the amount attributable to the unexpired term is less than $7,500 (75% of $10,000), the renewal period must be taken into consideration. In this case, the amount attributable to the unexpired term is 50% (5 years remaining unexpired)/10 years (5 years unexpired plus 5-year renewal). Therefore, the cost can be amortized only over 10 years (5 years remaining plus the 5-year renewal period).


Planning Pointer If the taxpayer can show that the lease will probably not be renewed, the renewal period need not be taken into account. Likewise, if the lease is actually renewed or it is reasonably certain that it will be renewed, the renewal period must be taken into consideration in any event.

Rehabilitation Outlays for Low-income Rental Housing

Rehabilitation expenditures generally are depreciated over the life of the building (Code Sec. 167). A low-income housing credit can be claimed for certain rehabilitation expenditures on low-income housing property placed in service after December 31, 1986 (with the exception of grandfathered property) (Code Sec. 42).

Amortization of Intangibles

Goodwill and other intangibles acquired after August 10, 1993 (or after July 25, 1991, for which a special election was made), and used in a trade or business or an activity engaged in for the production of income may be amortized over a period of 15 years, beginning in the month of acquisition. These assets are called “Section 197 intangibles.” The amortizable basis is generally the asset’s cost basis. If intangibles are acquired as part of the sale of a business, the residual method must be used to figure the allocated basis of intangibles (Code Sec. 197).

Section 197 Intangibles

1. Section 197 intangibles include purchased goodwill; going-concern value; workforce in place; information base; know-how; any customer-based intangible; any supplier-based intangible; any governmental unit or agency license, permit, or other right; patents, covenant not to compete; and any franchise (other than a sports franchise), trademark, or trade name.


2. Section 197 intangibles do not include self-created intangibles; interests in

a corporation, partnership, trust, or estate; interests under certain financial contracts; interests in land; certain computer software; certain separately acquired rights and interests; interests under existing leases of tangible property; interests under existing indebtedness; certain residential mortgage servicing rights; and certain corporate transaction costs.

Trademark Expenditures

Expenses incurred in the registration, protection, or defense of a trademark or trade name would normally be treated as capital expenses that can be amortized over their useful life. However, a trademark or trade name is a Section 197 intangible if acquired with the purchase of a business and can be amortized only over a 15-year period.

Study Question

In 2019, Guy Edmonds buys a local stationery store. A portion of the purchase price is allocated to goodwill. He can amortize the goodwill over:

A period of at least 60 months

15 years

39 years

Any period that the taxpayer selects

Special Amortization for Pollution Control Facilities

To encourage owners and operators of plants causing air or water pollution to invest in pollution control devices, the Code permits an accelerated write-off for expenditures made or incurred for that purpose (Code Sec. 169).


Business Start-up Expenditures

A deduction of up to $5,000 can be claimed for start-up costs in the year in which the business begins (Code Sec. 195). Any start-up costs not deductible under this rule can be amortized ratably over a period of 180 months (15 years). (Different rules had applied to start-up costs incurred prior to October 22, 2004.) The amortization period for start-up costs mirrors the write-off period for acquired intangibles under Code Section 197. The $5,000 limit is reduced by one dollar for each dollar of costs exceeding $50,000, so that no first-year deduction is allowed if start-up or organizational costs exceed $55,000. (For 2010 only, there was a $10,000 limit; it was reduced by one dollar for each dollar of costs exceeding $60,000, so that no first-year deduction was allowed if start-up costs exceeded $70,000.) Planning Pointer For businesses that had start-up costs over the dollar limit and go out of business, the unamortized portion of these costs can be deducted in the final year. The definition of “start-up expenditures” includes amounts incurred or paid before, and in anticipation of, the start of the business in an activity for profit or production of income, but does not include any amount with respect to which a deduction is allowable under Code Sections 163(a), 164, or 174.

Organizational Costs

The same rules for start-up costs apply to organizational costs for partnerships (Code Sec. 709) and corporations (Code Sec. 248). Planning Pointer To elect the current deduction and amortization of costs over $5,000, simply report the deduction on the return (called a deemed election). No special statement or attachment explaining the deduction is required for expenses incurred after September 8, 2008.


Optional 10-Year Amortization of Certain Preferences

Taxpayers can elect to amortize certain tax preferences over a 10-year period. These preferences include mining exploration and development costs, research and experimental expenditures, and intangible drilling costs. A 3-year period applies to circulation expenditures. When the amortization is elected, individuals do not have preferences for the alternative minimum tax (Code Sec. 59(e)). Planning Pointer The election is made on a statement attached to the original (or amended) return for the year in which amortization begins. A separate election is required for each project or activity. The statement must contain specified information (Reg. §1.59-1).

Depletion

Taxpayers who own mineral deposits, oil and gas wells, standing timber, or other so-called wasting assets are permitted to take a “depletion” deduction to make allowances for reduction in the remaining assets as resources are diminished. In other words, depletion is a form of “depreciation” of natural resources (Code Secs. 611–613). There are two methods of computing depletion:

Cost depletion

Percentage depletion Cost depletion may be used for all assets subject to depletion; percentage depletion may be used for most, but not all, assets (except by the larger oil and gas producers).

Cost Depletion

To calculate cost depletion, first divide the adjusted basis of the property (cost minus prior-year depletion allowances, cost, or percentage) by the number of


estimated recoverable units (tons, barrels, etc.) in the mine, well, or deposit. The resulting figure is “depletion per unit.”

Adjusted basis = Depletion per unit No. of units remaining as of the

beginning of the taxable year

Next, multiply depletion per unit times the number of units either for which payment is received during the tax year (if on the cash basis), or by the number of units sold (if on the accrual basis) (Code Secs. 611 and 612). Example Mel Houston owns an oil well with an estimated recoverable reserve of 50,000 barrels. The adjusted basis is $10,000. During the year, he sold and received payment for 8,000 barrels. Using the cost depletion method, he will claim a depletion allowance of $1,600($10,000 ÷ 50,000 = 20¢ per barrel. 8,000 barrels x 20 cents = $1,600).

Percentage Depletion

Under this method, the taxpayer may deduct a certain percentage of gross income from the resource during each year, but the deduction in any year may generally not exceed 50% of the taxable income from the property, computed without the deduction for depletion (Code Sec. 613). In no event, however, may the deduction be less than the amount available if computed on the cost basis. Note that timber is excluded from this method. The major depletion percentages are as follows:

Sulfur and uranium 22%

Gold, silver, copper, iron ore, and oil shale (with some exceptions) if from mines or deposits in the United States

15%

Coal and sodium chloride 10%

Gravel, peat, and pumice sand 5%

Asbestos, bauxite, graphite, lead, mica, nickel, platinum, zinc, and most other minerals and metals if from mines or deposits in the United States

22%

Gold, silver, copper, iron ore, and most other minerals and metals extracted from non-U.S. mines or deposits

14%


There is no oil and gas percentage depletion allowance for larger companies. It is important to note that taxpayers may continue to take allowances for percentage depletion even after they have recovered their cost or other basis. This provision was designed to encourage the exploration of natural resources through granting producers a singular tax advantage not enjoyed by other taxpayers. For the same reason, the depletion deduction may generally be taken only during the period the natural resources are actually being extracted from the property. Taxpayers engaged in the development and exploration of geothermal resources are eligible for a depletion allowance of 15%. Where taxpayers lease wells or mines in return for royalties to be received for each unit removed (as is frequently the case), their gross income from the property is ordinarily the sum of the royalties received from the lease (including any bonus, but excluding rentals). If owners (or lessors) of resource property receive from lessees minimum royalties, which are payable even if the oil, gas, or minerals are not extracted, they are still entitled to the depletion allowance. However, no further deduction is allowed if and when the extraction actually takes place. If the lease is ended before all the minerals paid for by the minimum royalties have been extracted, the depletion allowance taken for those minerals paid for but not removed must be included in income. Of course, the basis of the property would be increased by the same amount since that portion of the depletion is, in effect, nullified. Just as in the case of depreciation, the amount of depletion allowed (or allowable, even though not actually taken) reduces the basis of the property. The depletion “allowable” is the greater of cost or percentage depletion, regardless of which method was actually used.

Percentage Depletion as a Tax Preference

The amount by which percentage depletion deductions taken exceeds the basis of the resource property (not counting any depletion in the tax year) is a tax preference. The tax preference is not necessarily the difference between percentage depletion and cost depletion.


No tax preference arises until total percentage depletion on the property over the years equals the basis of the property. After the year that total percentage depletion equals the property’s basis, every dollar of percentage depletion is a dollar of tax preference.

Who is Entitled to the Depletion Deduction?

Anyone who owns or has an “economic interest” in an oil or gas well, mine, timber, or other resource property subject to depletion is entitled to the depletion allowance. The Supreme Court has ruled that any person entitled to a share of oil and gas in place, or who has a right to a share of production, has an “economic interest” and is therefore entitled to the allowance. Thus, the owner of ocean shore property that provided the only available site from which to drill oil from adjacent submerged coastal lands and who received a share of the profits for permitting use of the land was held entitled to the depletion allowance, even though the actual oil deposit was not located on the property.

Study Question

A business begins operations on January 1, 2019. It had paid start-up costs of $23,000. What can be deducted in 2019?

$5,000

$10,000

$6,200

$23,000

Study Question

With respect to percentage depletion, which statement is not correct?

It may not be used after the taxpayer has recovered his or her basis in the property.


It cannot exceed 50% of taxable income from the property.

It may give rise to a tax preference item.

Anyone who has an “economic interest” in a depletable property is entitled to an allowance

Business Losses

A loss from business activities may result when expenses exceed income. There are various tax rules that may limit a deduction for losses.

Casualty and theft losses

Hobby losses

Net operating losses

Noncorporate excess losses Other rules discussed later in this program in connection with rental activities that limit loss deductions are the passive activity loss rules and the at-risk rules.

Casualty and Theft Losses

If business property or property held for the production of income is completely destroyed, the deductible loss is the adjusted basis of the property, less any salvage value and any insurance or other compensation received or recoverable (Code Sec. 165).

Planning Pointers and Examples Planning Pointer The loss is deductible in full and is not subject to restrictions and limits imposed on nonbusiness casualty losses. Example Tom Harding owns a building, which cost him $130,000. He uses it for rental purposes. It was completely destroyed by a tornado. The total depreciation


allowable up to the time of the loss was $26,000, and his insurance and salvage recovery was $100,000. He would compute his casualty loss as follows:

Cost $130,000

Less Depreciation 26,000

Adjusted basis $104,000

Less Salvage and insurance recovery 100,000

Total loss deductible $4,000

Example If business property is partially destroyed, the deductible loss is:

1. The decrease in value due to the casualty 2. The adjusted basis of the property damaged, whichever is smaller,

reduced by insurance or other compensation received

Example Assume that Tom’s building was only partially destroyed by the storm, and that the fair market value of the building was $120,000 immediately before the storm and $85,000 immediately after. The loss is the decrease in value, $35,000, since this is less than the adjusted basis of $104,000. Planning Pointer To accurately determine the difference in the fair market value of the property immediately before and after the loss, a competent appraiser should be employed. The cost of repairs to damaged property is also acceptable as proof of the amount of the loss, provided that the repairs do no more than restore the property to its condition immediately before the casualty and that the amount spent for such repairs is not excessive. The cost of clearing the property of debris is also deductible.


How Casualty Losses are Deducted Casualty losses of business property are deductible from gross income in computing adjusted gross income. The same applies to casualty losses of property held for the production of rents and royalties. If the property is held partly for business purposes and partly for personal purposes, the casualty or theft loss deduction must be computed as though two separate pieces of property had been stolen, damaged, or destroyed—one business and the other nonbusiness. All business casualty losses must be grouped together to determine if there is a net gain or net loss. If a net gain results, all such casualty gains and losses are combined or “netted” with any regular non-casualty, Section 1231 gains and losses to determine if there is a net gain on Section 1231 assets; such gain would be taxed as long-term capital gain. If a net loss results from casualties, it does not come under Section 1231, and the loss is therefore fully deductible as an ordinary loss. The calculation is done on Part II Form 4684, Casualties and Thefts. Example Oliver Jones had an uninsured loss of $5,000 resulting from the destruction by fire of property he used in his business. He also had a recognized gain of $3,000 resulting from an insurance recovery on business property used in his business, which was destroyed by a tornado. Because his losses exceed his gains, neither is subject to Section 1231. The net effect is an ordinary loss deduction of $2,000.

Business Casualty Loss Rules Business casualty loss rules can be summarized as follows:

Step 1: Casualty and theft gains and losses are netted.

Step 2: If a net loss results, take it as an ordinary deduction.

Step 3: If a net gain results, take it into account under Section 1231 gains and losses. If the total is a gain, Section 1231 is applicable. If the total is a loss, all gains and losses are ordinary.


When to Deduct a Casualty Loss In general, casualty losses are deductible only in the tax year in which the casualty occurs. This is true even though the property may not be repaired or replaced until a later year. However, theft and embezzlement losses are deductible only in the year the loss is discovered, not in any other year in which the theft or embezzlement may have occurred.

If the amount of the loss sustained cannot be determined before the due date for filing the return, the taxpayer can file Form 4868 to obtain the automatic 6-month extension of time to file.

If the taxpayer reasonably expects to receive insurance or other

compensation but has not received it by the end of the year in which the casualty occurred, the loss deduction must be reduced by the estimated amount of insurance or other compensation to be received.

If the taxpayer subsequently receives less than the amount originally

estimated, he is entitled to an additional loss deduction in the year the claim is settled.

Example Steve Candler owned business property with an adjusted basis of $10,000 that is completely destroyed by fire in 2019. Steve’s only claim for reimbursement consists of an insurance claim for $8,000, which is settled in 2019. Steve sustained a loss of $2,000 in 2019 and should claim it in that year. Planning Pointer If a loss is claimed and an unexpected insurance recovery is later received, the amount of the loss must be reported as income in the year of the insurance recovery. The return for the loss year is not amended, even if that year is not yet closed by the statute of limitations.


Hobby Losses (Activities Not Engaged in for Profit) There is a “hobby loss” rule that limits deductions attributable to an activity not engaged in for profit (Code Sec. 183). If the activity is not engaged in for profit, income must be reported as “other income,” but the taxpayer may not deduct any expenses in 2018 through 2025 because of the suspension of miscellaneous itemized deductions.

Presumption of Profit Move

A taxpayer will be presumed to engage in a profitable activity if, in any 3 out of 5 consecutive years ending with the current year, the activity produces a profit, or, in the case of breeding, training, showing, or racing horses, in 2 out of 7 consecutive taxable years. The IRS can overcome this presumption, however.

A taxpayer who suffers losses in the first couple of years and who wants to rely on the presumption can file an election to do so on Form 5213, Election To Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit. In effect, this keeps the IRS from challenging a profit motive until the end of the 5-year testing period.

Example and Pitfall

Example Rick Johnson starts a dog-breeding business in 2019 and incurs losses with very little income. He can file Form 5213 to prevent the IRS from questioning losses from this activity that he has reported on Schedule C until after 2023.

The election must be made within 3 years of the due date of the return for the first year of the activity. In the example above, the election must be made by April 15, 2023 (within 3 years from April 15, 2020, the due date for the 2019 return, the year in which the dog-breeding activity started).

If the IRS questions any deductions before the end of this 3-year period and an election has not yet been made, an election can still be put into effect.


The election must be made within 60 days of receiving a deficiency notice from the IRS. Pitfall It is not advisable in most cases to make the election to postpone determination of profit motive on Form 5213. Doing so virtually guarantees that the IRS will look at affected returns, and the election extends the statute of limitations for all items on the return related to the activity.

Study Question To rely on a presumption that an activity (other than a horse-related activity) has a profit motive in order to avoid the hobby loss rules, a taxpayer must show a profit in how many consecutive years?

2 out of 5 years

3 out of 5 years

2 out of 7 years

3 out of 7 years

Net Operating Losses If taxpayers sustain a net loss in the operation of their trade, business, or profession, or from a disaster impacting personal-use property loss, and such loss or losses exceed their income from other sources, they have a net operating loss that may be used to reduce their income subject to tax (as adjusted) for other years (Code Sec. 172). For losses arising in tax years ending after 2017, they can only offset up to 80% of taxable income in the carryover year; no carryback is allowed (other than for farming losses). Defined simply, a net operating loss is the excess of allowable deductions over gross income after certain adjustments described below are applied to that excess. They also include noncorporate excess business losses in 2018 through 2025. Noncorporate excess business losses are explained later in this program.


How the Net Operating Loss is Computed The following is a summary of the rules for NOLs. A net operating loss is computed in the same way as taxable gross income less deductions, with the following exceptions shown on screen.

Capital losses may not exceed capital gains. Furthermore, nonbusiness capital losses may not exceed nonbusiness capital gains, even though the taxpayer’s capital gains derived from business activities exceed his or her business capital losses.

Nonbusiness deductions may not exceed nonbusiness income.

No net operating loss carryovers or carrybacks (allowable only for farming businesses) from other years are considered.

Computation of Net Operating Loss: Taxable income shown on the return Add back:

1. Personal and dependency exemptions (not applicable from 2018 through 2025).

2. Net operating loss carryover from another year. 3. The qualified business income deduction. 4. The excess of nonbusiness capital losses over nonbusiness capital gains. 5. The excess of nonbusiness deductions over the sum of nonbusiness

income plus net nonbusiness capital gains. 6. The excess of business capital losses over the sum of business capital gains

plus the excess of nonbusiness income and net nonbusiness capital gains over nonbusiness deductions.

Note: The add-back from the total of items 4 and 6 will not exceed $3,000 because of the capital loss limitation rules. Equals: The net operating loss Planning Pointer No special form is used to figure the net operating loss. Instead, attach a statement to the return that shows how the net operating loss deduction was


figured. Schedule A of Form 1045, Application for Tentative Refund, can be used as a guideline to determining a current year net operating loss.

Business or Nonbusiness Income and Expenses for NOLs Because nonbusiness deductions may be claimed only to the extent of nonbusiness income in computing a net operating loss, it is necessary to distinguish between business and nonbusiness income and expenses. For purposes of the net operating loss computation, salaries and wages are considered as trade or business income. Business Loss Also, a loss sustained in the operation of rental property is considered a business loss. Losses on Code Sec. 1244 stock and the taxpayer’s pro rata share of losses from an S corporation or partnership are allowable as business losses in computing the net operating loss. Any gain or loss on the sale or other disposition of real or depreciable property used in a trade or business is included at 100%. Casualty and Theft Losses Losses from a casualty or theft of property used for personal purposes in a federally declared disaster are treated as attributable to a trade or business in computing the net operating loss. However, a casualty loss to personal-use property in a federally-declared disaster is subject to the 10%-of-adjusted-gross-income limit and the $100 floor. Planning Pointer Prior year net operating losses are not considered in determining current year NOL’s.

Loss Carrybacks and Carryovers The carryback and carryover periods for net operating losses depend on the year in which the net operating loss arose.


NOLs arising in tax years ending after 2017 have no carryback; there is an indefinite carryforward. The only exception is for farming NOLs which have a 2-year carryback. (There are also special rules for casualty and property insurance companies not discussed here.)

NOLs arising in tax years before 2018 had a 2-year carryback and 20-year carryforward.

There was a 3-year carryback for NOLs resulting from casualty losses for individuals and

small businesses and farmers attributable to federally-declared disasters. There was a 5-year carryback for farming losses and a 10-year carryback for specified liability losses.

Planning Pointer Taxpayers must keep track of net operating losses from each year separately so that the appropriate carryback and carryover period can be used. Schedule A of Form 1045, Application for Tentative Refund, is a worksheet that can be used to compute net operating loss on a year-by-year basis.

Foregoing the Carryback

A taxpayer in a farming business who is eligible for a carryback can elect to forego it and simply carry the loss forward. The election is made on a statement attached to the return for the year of the loss. The election cannot be made after the due date for filing the return (including extensions). The election is irrevocable.

Computing Net Operating Loss Deduction Before computing the net operating loss deduction for the year, it must be determined what part of any operating losses for any preceding or succeeding tax years represents carryovers or carrybacks to the tax year under consideration. The sum of the net operating loss carrybacks and carryovers, then, is the net operating loss deduction for the tax year. For example, assuming that the 2-year NOL carryback period applies for a farming loss arising in 2019, the net operating loss is carried back to the second tax year preceding the year in which it is sustained (2017). Any amount of the loss not used to offset income subject to tax (adjusted, as explained below) for the second preceding year (2018) is carried to the first preceding year.


If the loss is not entirely used to offset income subject to tax (adjusted) in the 2 preceding years, the balance may be carried forward to the succeeding year (2020) and so on until it is used up. If the taxpayer has more than one net operating loss to be carried to the same tax year, the loss from the earliest year is applied first. Example Art Becker had net operating losses of $10,000 and $15,000, respectively, in the years 2017 and 2018. The 2017 NOL is applied first against 2019 taxable income. Then the 2018 NOL is applied. Because these NOLs arose in tax years beginning before 2018, they can be used in full to offset taxable income.

Net Operating Loss Deduction In making a claim for a net operating loss deduction, the taxpayer must file a return for the year of the deduction a concise statement setting forth all related facts, including a detailed schedule showing how the deduction was computed. Schedule A of Form 1045, Application for Tentative Refund, can be used to calculate a current year net operating loss. The net operating loss deduction is claimed on Schedule 1 of Form 1040 or 1040-SR as a negative entry under “other income" (list this as “net operating loss” and enter the amount). Planning Pointer The net operating loss carryovers will not change the self-employment tax due for the carryover year.

Modifications

The amount of the loss that may be carried to another year, after applying it to an earlier year or years, is the excess of the net operating loss over the income subject to tax of the earlier year or years, computed with the following modifications:


1. The deduction for capital losses may not exceed the capital gains included in gross income.

2. Income subject to tax is determined without regard to the particular net

operating loss being carried back or forward, or to any later net operating loss. Any earlier net operating losses being carried over from other years may be taken into account.

3. Any deductions claimed, except charitable contributions, which are based

on or limited to a percentage of adjusted gross income or income subject to tax (such as medical expenses), must be recomputed on the basis of the adjusted gross or income subject to tax after applying adjustments 1 and 2 above.

The income subject to tax so computed is not to be reduced to less than zero.

Study Question

A is in the restaurant business. The ordinary net operating loss carryback for losses arising in 2019 is:

Zero

2 years

3 years

5 years

Excess Business Losses of Noncorporate

Taxpayers For 2018 through 2025, noncorporate taxpayers, such as sole proprietors filing Schedule C or F, cannot take an immediate deduction for excess business losses. Instead, the excess is treated as a net operating loss carryover to the following year. The passive activity loss (PAL) rule applies before the application of the excess business loss rule. An excess business loss in 2019 is the excess, if any, of:


Trade or business deductions for the year, over

The sum of (1) gross income or gain for all of a taxpayer’s trades or businesses for the year plus, in 2019, (2) $255,000 ($510,000 on a joint return).

For partners and S corporation shareholders, the limit is applied at the owner level. Each owner’s pro rata share of items of income, gain, deduction, or loss is taken into account by the owner in applying the excess business loss rule. Farm Income and Expenses

Farming is a business activity for which the same rules addressing business activities discussed earlier in this course apply. However, there are certain income and deduction rules unique to farming activities.

Farming Income

Farming activities in raising crops and animals usually produce ordinary income. There are some special rules. Rents, including crop shares, usually are reported as rent and not as farm income. Income from crop shares is reported on Form 4835. However, if the taxpayer materially participates in the farming activities, then the rents are ordinary farm income. Crop shares received as a landlord and fed to livestock are considered converted to money when fed to the livestock. The fair market value of the crop shares is included in income at that time. Planning Pointer The farmer is entitled to a business expense deduction for the livestock feed in the same amount and at the same time the farmer includes the fair market value of the crop share as rental income.

Other Income Items

Other income items include:


1. Agricultural program payments, whether received in cash, materials, services, or commodity certificates (e.g., livestock indemnity payments, livestock forage disaster payments, price loss coverage payments)

2. Conservation Reserve Program (CRP) rents received to convert cropland to less intensive use

3. Crop insurance and crop disaster payments 4. Feed assistance and payments 5. Lime and fertilizer received under a government program 6. National Tobacco Growers’ Settlement Trust Fund payments 7. Patronage dividends 8. Payments under the Agricultural Act of 2014 9. Payments under the Farm Security and Rural Investment Act of 2002 10. Payments under the Food, Conservation, and Energy Act of 2008

Planning Pointer Cost-sharing payments under a federal or state program for conservation, reclamation, or restoration are excludable from income if certain conditions are met.

Commodity Credit Corporation (CCC) Loans

While the proceeds of loans usually are not income, if all or part of production is pledged to secure the loan, it can be treated as a sale of crops and reported as income in the year in which the proceeds are received. Pitfall Once a farmer opts to treat CCC loan proceeds in this way, he or she must continue to do so in later years. However, an automatic consent procedure can be used to change this reporting method.

Deductions

Again, the deductions discussed earlier for other businesses apply for farming businesses. Here are some special deduction rules.


Prepaid Farm Supplies A cash method farmer can deduct prepaid farm supplies in the year paid for them up to 50% of other deductible farm expenses for the year (all Schedule F deductions except prepaid farm supplies). This limit does not apply (i.e., the cost is fully deductible) if either:

Prepaid farm supplies expense is more than 50% of other deductible farm expenses because of a change in business operations caused by unusual circumstances

Total prepaid farm supplies expense for the preceding 3 tax years is less than 50% of total other deductible farm expenses for those 3 tax years

Prepaid Livestock Feed A farmer cannot deduct in the year paid the cost of feed that livestock will consume in a later year unless all the following tests are met:

The payment is for the purchase of feed rather than a deposit.

The prepayment has a business purpose and is not merely for tax avoidance.

Deducting the prepayment does not result in a material distortion of income.

If all tests are met, prepaid feed is deductible, subject to the limit on prepaid farm supplies discussed earlier. Other Deductions Here are some other farm-related deductions, some of which may have special rules on timing not discussed here:

Breeding fees

Crop scouting expenses

Dues to cooperatives

Fertilizer and lime

Ginning

Insect sprays and dusts

Livestock fees

Marketing quota penalties

Milk assessment


Tenant housing expenses for hired help

Veterinary fees Nondeductible Expenses Here is a list of common expenses that cannot be deducted:

Cost of unharvested crops bought with the land

Loss of livestock that die if the cost of raising them has been deducted

Loss of raising unharvested crops sold with land owned more than one year if both are sold at the same time

Loss on growing plants, produce, and crops (although there is an exception for losses on plants with a preproductive period of more than 2 years)

Personal, living, and family expenses

Repayment of loans

Reporting Farm Income and Expenses

Income and expenses from farming are reported on Schedule F of Form 1040. The following are some special rules for farmers. The sale of livestock held for draft, breeding, sport, or dairy purposes may result in ordinary or capital gains or losses, depending on the circumstances. In either case, these sales are reported on Form 4797 Sale of Business Property. If a farmer sells or exchanges more livestock, including poultry, than normal because of a drought, flood, or other weather-related condition, the gain can be postponed from the additional animals until the next year. Planning Pointer Farmers may be eligible to average their income in order to lower their overall tax. This is figured on Schedule J of Form 1040 or 1040-SR. Income averaging is explained in 1040 Preparation and Planning 12: Figuring Tax Liability.

Study Question

All of the following are currently deductible farm expenses except:


Cost of unharvested crop bought with the land

Breeding fees

Prepaid livestock feed

Tenant housing expenses

Rents and Royalties

Income in the form of rents and royalties is reportable. However, a taxpayer receiving such income is permitted to deduct all ordinary and necessary expenses incurred in connection with the property (subject to the “passive loss rules” discussed below). Such expenses are deductible even though the taxpayer is not in the trade or business of renting property. This constitutes one of the few exceptions to the rule that only trade or business expenses may be deducted from gross income. Example Bruce Jenkins received $1,200 monthly from the rental of a single-family home ($14,400 annual rental income). His deductions in connection with the rented house were as follows: taxes, $4,800; mortgage interest, $7,200; repairs, $450; depreciation, $1,540; and miscellaneous expenses, $250.

Rental Income $14,400

Less: Expenses incurred in 14,240

producing the rental income

Net income from rents $160

Examples of royalties are earnings from patents, copyrights, trademarks, mines, and oil wells. If part of the income-producing property is occupied by the taxpayers for their personal residence, only a proportionate part of the expenses may be deducted. An allocation may be made under any one of several methods.

Example Fred Barton owns a four-family house, where he occupies one apartment and rents out the other three at a total yearly rental of $26,000. All apartments are of approximately equal size and rental value.


His expenditures for interest, taxes, heat, repairs, depreciation, etc. amounted to $32,000. The net income from rents and the adjusted gross income would be determined as follows:

Gross rents $26,000

Total deductions $32,000

Less 1/4 for personal use 8,000

Amount deductible from gross income 24,000

Net income from rents 2,000

If any part of the expenditures is made solely for the benefit of the tenants, that amount is, of course, entirely deductible.

Example Assume the same facts as in the previous example, except that Fred, in addition to the above expenses, pays $3,000 for having the inside of the three rental apartments painted. The income would be computed as follows:

Gross income from rents $26,000

Allocable expenses $32,000

0

Less 1/4 for personal use 8,000

$24,000 Painting expense 3,000

Total amount deductible from gross income 27,000

Net income from rents (loss) (1,000)

Note from the above example that, just as a net profit from rents is added to other income in computing adjusted gross income, a net loss is deducted and will thus reduce the adjusted gross income(if the loss is allowable under the passive loss rules).

Reporting Rental and Royalty Income and Expenses

Rental income and expenses generally are reported on Schedule E. However, if rental activities constitute a trade or business, then income and expenses are reported on Schedule C or Schedule C-EZ.


Similarly, royalties and related expenses generally are reported on Schedule E. However, royalties related to a trade or business, and oil and gas working interests are reported on Schedule C or Schedule C-EZ. For example, an investor reports oil and gas royalties on Schedule E, but a freelance writer report royalties from book sales on Schedule C (or C-EZ). Pitfall Rental expenses may not be currently deductible. Rental losses are limited by the passive loss rules and the at-risk rules.

Advance Rents

Rental income includes advance rents, which must be included in the year received, regardless of whether the taxpayer is on a cash or accrual basis. Security deposits, however, are usually not includible in income when received, unless the agreement provides that the deposit shall be applied as payment of the rent for the last month or year of the lease, in which case it is reportable as advance rent and, therefore, treated as income in the year of receipt. If the owner of the property receives a payment for permitting the tenant to transfer the lease, that amount should be reported as rent. It constitutes gross income for the year in which it is received. If the tenant pays any of the expenses of the landlord, such as real estate taxes, such payments also are rental income.

Passive Activity Loss (PAL) Rules

In general, the PAL rules apply to trades or businesses in which an owner does not materially participate and to rental real estate activities, regardless of participation. The PAL rules operate to limit deductions to the extent of passive activity income, with some exceptions (Code Sec. 469). Thus, for example, a partner cannot take his share of a limited partnership (passive activity) loss in a particular year. Instead, the losses in excess of passive activity income are carried forward and can be used in a subsequent year if there is passive activity income to offset the losses.


Members of limited liability companies are not automatically treated as passive investors for purposes of the passive activity loss rules as are limited partners..

In general, regulations define when interest on a loan by an owner to a partnership or S corporation engaged in a passive activity will be treated as passive activity income. Specifically, the portion of the income that must be recharacterized as passive income is the income item multiplied by the greater of the share of the self-charged interest or the owner’s income from the entity. Example The AB Partnership (“Partnership”), owned equally by Alice Gatewood and Brenda Sykes, owns and manages a piece of rental property. The Partnership borrows $50,000 from Brenda. The Partnership pays Brenda $5,000 interest. Alice’s and Brenda’s shares of the Partnership’s interest expense are $2,500 each. Brenda must recharacterize $2,500 of her $5,000 interest income as passive activity income. Similar rules apply to recharacterize deductions under the self-charged interest (or self-charged rental) rule (Reg. §§1.469-2(f)(6) and 1.469-2T(f)). This rule recharacterizes what would otherwise be passive income (from rent, interest) as nonpassive income so that it cannot be used to offset passive losses. Example A doctor’s practice paid rent to an S corporation he set up to own the office building where his practice is located. Under the self-charged rental rule, the rent is recharacterized as ordinary income. The doctor cannot use this income to offset his passive activity losses from other ventures (Williams, TC Memo 2015-76, aff’d per curiam in unpublished opinion, CA-5, 2016-1 USTC ¶50,173).

Suspended Passive Activity Losses Suspended passive activity losses can also be taken in the year in which there is a complete disposition of an interest in a passive activity. For example, if a rental real estate building is sold, then suspended losses related to the building can be claimed, even though they exceed passive activity income


for the year. Individuals with passive losses are required to file Form 8582, Passive Activity Loss Limitations, to figure their loss limitations. In order to fall outside the PAL rules for rental activities other than real estate, a taxpayer must “materially participate” in the activity. Material participation can be satisfied only with regular, continuous, and substantial participation in operations as defined by regulations.

Tests to Determine Material Participation Reg. §1.469-5T of the Regulations specifies 7tests used to determine material participation. The taxpayer must meet one of the following tests: Tests Based on Current Participation

1. Taxpayer participates more than 500 hours during the year. 2. Taxpayer’s participation in the activity constitutes substantially all of the

participation of all individuals in the activity during the year 3. Taxpayer participates more than 100 hours during the year, and such

participation is not less than the participation of any other individual. 4. Taxpayer participates more than 100 hours during the year in one activity,

and the aggregate participation in all more-than-100-hour activities exceeds 500 hours.

Tests Based on Prior Participation 5. Taxpayer materially participates for any 5 taxable years during the

preceding 10 years. 6. The activity is a personal service activity, and the taxpayer materially

participates for any 3 years (whether or not consecutive) preceding the current year.

Test Based on Facts and Circumstances 7. Facts and circumstances show regular, continuous, and substantial

participation during the year. Planning Pointer The same material participation tests apply for purposes of determining whether income from a business interest is investment income for purposes of the additional 3.8% Medicare tax on net investment income.


Exception for Real Estate Professionals Those who sustain losses from “real estate trades or businesses” are not subject to the passive loss rules. To qualify for this exception, an individual must meet certain requirements:

1. More than 50% of his or her personal services during the year must be performed in real property trades or businesses in which there is material participation

2. The individual must perform more than 750 hours of service in the real

property trades or businesses in which he or she materially participates

Exemption An employee who owns more than 5% of stock in a closely held real property trade or business can qualify for the exemption if the participation tests are met. In the case of married persons, each spouse who claims to be a real estate professional must individually meet all of the requirements (Code Sec 469(c)(7)). Casualty and theft losses to rental property can be deducted in the year in which they occur without regard to the passive loss limits, unless such losses regularly occur in the rental activity (Reg. §1.469-2T(d)(2)). Exception for Active Participants Even though a taxpayer is not a real estate professional, rental losses up to a set dollar limit may be currently deductible. Under a special rule for real estate rentals, a loss of up to $25,000 may be taken annually if the owner actively participates in the rental activity and if adjusted gross income does not exceed $100,000. For adjusted gross income between $100,000 and $150,000, the $25,000 is phased out so that no loss is allowed for those with adjusted gross income of $150,000 or more. Married persons must file jointly to claim this special allowance. Married persons who file separately and live apart have a $12,500 rental loss allowance and the phaseout begins at $50,000 of AGI. No allowance can be claimed for married persons who live together. To qualify for the $25,000 exception, a taxpayer must:


Actively participate in the real estate rental activity, and

Own 10% or more (in value) of all interests in the activity during the entire taxable year (or shorter period during which the taxpayer held an interest in the activity).

Figuring Passive Activity Loss Limitations The extent to which losses can be claimed currently are figured on Form 8582, Passive Activity Loss Limitations. Pitfall The PAL rules are not limited to deductions. They also apply to tax credits. The limitation on credits is figured on Form 8582-CR, Passive Activity Credit Limitations. At-risk Rules If an activity produces a loss, in addition to addressing the passive loss rules, there is another potential limitation: at-risk rules (Code Sec. 465). Essentially, this rule limits losses to the amount of a taxpayer’s economic investment in the activity. It is designed to prevent the creation of losses for which the taxpayer bears no risk of loss in the activity. The at-risk limitation is figured on Form 6198, At-Risk Limitations. Reporting Income and Losses Income from rents and royalties is reported on Part I of Schedule E of Form 1040 or 1040-SR.

Study Question Sue Sheldon owns rental real estate that results in a $14,000 loss. Assume that her AGI is $200,000 and she has no passive activity income. Sue loses the benefit of the $14,000 loss.

True

False


Rental of a Home If a taxpayer owns and rents out a vacation home or other dwelling unit that is also used as a residence, certain restrictions apply to rental expenses (Code Sec. 280A). Expenses must be allocated between the rental use and the personal use. The rules governing the reporting of income and expenses are referred to as the vacation home rules. For purposes of allocating expenses, any day that the unit is rented at a fair rental value is a day of rental use, even if the taxpayer has personally used the unit for that day. A unit is not considered used for rental during the time that it was held out for rent. A taxpayer is considered to use a dwelling unit as a residence during the tax year if he used it for personal purposes more than 14 days or more than 10% of the number of days during the tax year it is rented at a fair rental, whichever is greater. Example Vicki Ames owns a beach house. She rented it during June and July (61 days) and used it herself in August (31 days). Vicki used the home as a residence because she used it for personal purposes for more than 14 days and more than 10% of the number of days it was rented. If the residence is not used for personal purposes (i.e., personal use does not exceed the greater of 14 days or 10% of rental) but it is rented out for 15 days or more during the year, then rental expenses fall within the passive loss rules.

Rental for Less Than 15 Days If a taxpayer uses the unit as a residence and rents it for less than 15 days during the year, no rental expenses can be deducted. However, if the taxpayer itemizes deductions, he can deduct mortgage interest on a second home, taxes, and casualty and theft losses. No rental income is included in gross income in this case.


Personal Use Exceeds the Greater of 14 Days or 10% of Rental and Rental is 15 Days or More Deductions (other than mortgage interest, property taxes, and casualty losses) cannot exceed rental income. A taxpayer must deduct rental expenses in the following order:

1. Mortgage interest, real estate taxes, and casualty losses that are for rental use

2. Operating expenses, except depreciation and other basis adjustments 3. Depreciation and other basis adjustments

Category Expenses

1. Deductible whether or not there is any rental income and, thus, can produce a loss.

2. Deductible only to the extent that rental income exceeds category (1) expenses. Category (2) expenses cannot produce a loss.

3. Deductible only to the extent that rental income exceeds both category (1) and category (2) expenses; excess expenses cannot be deducted as a loss.

Tax Court It is the Tax Court's position that mortgage interest and real estate taxes are not subject to the same percentage limitations as are other expenses because they are assessed on an annual basis without regard to the number of days that the property is used. Two appellate courts agree with the Tax Court (Bolton, CA-9, 82-2 USTC ¶9699 and McKinney, CA-10, 83-2 USTC ¶9655). The formula employed by the Tax Court computes the percentage limitation for interest and taxes by dividing the total days rented by the total days in the year, creating the potential of leaving more gross rental income to offset allocated rental expenses.


Planning Pointer Proposed regulations reflecting the IRS position, which differs from the Tax Court’s position, are still pending (Prop. Reg. §1.280A-1 through 1.280A-3, 7/21/83).

Reporting Rental Income and Expenses Rental income and all the expenses for rental use are reported on Schedule E of Form 1040 or 1040-SR. Where the vacation home expenses are subject to the passive loss rules, Form 8582, Passive Activity Loss Limitations must also be used. Interest, taxes (subject to the overall $10,000 cap on state and local taxes [SALT]), and disaster losses for personal use of the property are deducted on Schedule A of Form 1040. If personal use does not exceed the greater of 14 days or 10% of rental days, then the vacation home rules do not apply. If the home is rented out, then expenses may be deductible under ordinary rental rules. No Personal Use If a taxpayer does not use the residence at any time during the year, the vacation home rules do not apply. In such a case, the general rules for rental realty discussed earlier in this program apply. More specifically, rents are taxable but any losses (expenses in excess of rental income) are subject to the passive activity loss rules.

Study Question With respect to the vacation home rules, which statement is not correct?

A home owner who rents out the home for less than 15 days has to report the income.

A home owner who rents out the home for less than 15 days cannot deduct any maintenance or depreciation on the home.

A home owner who rents out a home for 15 days or more and uses the home for more than 14 days or 10% of the rental period can deduct expenses (other than


mortgage interest, real estate taxes, and casualty losses) only to the extent of rental income.

A home owner who rents out the home for more than 15 days must report any income.

Qualified Business Income Deduction Owners of pass-through entities (sole proprietors, partners, limited liability company members, and S corporation shareholders) may be eligible for a special tax deduction. The deduction is a not a reduction to business income, gross income, or adjusted gross income; it reduces taxable income in the same way as the standard deduction or itemized deductions. Employees cannot take the deduction with respect to their compensation. The qualified business income (QBI) deduction essentially is 20% of business income (Code Sec. 199A). The deduction is subject to multiple limitations based on the taxpayer’s taxable income, the amount of W-2 wages paid with respect to the qualified trade or business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business. Specified service trades or businesses are subject to an additional limitation. Taxpayers with qualified business income (which does not include income from performing services as an employee) and with taxable income in 2019 under $160,700 for singles and heads of households, $160,725 for married persons filing separately, or $321,400 for joint returns, generally are eligible for the full 20% deduction. The QBI deduction in this case is figured on Form 8995, Qualified Business Income Deduction Simplified Computation. If taxable income exceeds the limits above, then apply the limitations. Limitations. The deduction is the lesser of:

20% of QBI, or

The greater of (1) 50% of W-2 wages (meaning taxable compensation, elective deferrals, and deferred compensation), or (2) 25% of W-2 wages plus 2.5% of unadjusted basis immediately after acquisition (UBIA) of qualified property.

Specified service trades or businesses (SSTBs)


These are trades or businesses that involve the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees (but not architecture or engineering). For these businesses, QBI and other items phase out for those with taxable income in 2019 between $321,400 and $421,400 for joint filers, $160,725 to $210,725 for married persons filing separately, and $160,700 to $210,700 for singles and heads of households. Where taxable income exceeds the applicable thresholds described earlier, use Form 8995-A, Qualified Business Income Deduction, to figure the amount of the deduction. There are 4 schedules accompanying this form:

Schedule A, Specified Service Trades or Businesses

Schedule B, Aggregation of Business Operators

Schedule C, Loss Netting and Carryforward

Schedule D, Special Rules for Patrons of Agricultural or Horticultural Cooperatives

Note: Final regulations address situations when businesses can be aggregated or separated, and other aspects of the QBI deduction (T.D. 9847, 2/8/19).

Final Exam All of the following are requirements for filing Schedule C-EZ except:

a) Business expenses not exceeding $5,000 b) Gross receipts under $100 c) No home office deduction d) No employees

Which of the following is not correct with regard to vacation homes?

a) Mortgage interest and property taxes are not deductible if expenses exceed rental income.

b) Where annual rental is fewer than 15 days, rental income is not reported, and no deductions are allowed (other than mortgage interest and taxes).


c) Where annual rental is 15 days or longer and personal use exceeds the lengthier of 14 days or 10% of the rental period, deductions and expenses are limited to rental income.

d) Where annual rental is 15 days or longer and personal use does not exceed 14 days or 10% of the rental period, property is treated as rental property subject to the passive loss limitations.

Accountable plans require all of the following except:

a) Advances be made within 30 days of expense b) Substantiation be provided to the employer within 60 days of expense c) The employer must file an annual return for the plan with the IRS d) Excess amounts be returned within 120 days of expense

Which of the following is not deductible as an “actual car expense” by a taxpayer who uses that method to figure the deductible cost of operating his car for business purposes?

a) Depreciation b) Gas and oil c) Parking fines d) Lease fees

In March 2019, Mitchell Dean bought a car used 100% for business. The car cost $96,000 and weighs less than 6,000 pounds (assume that Mitchell made no other equipment purchases in 2019). (Assume no election out of bonus depreciation.) In 2019, Mitchell may claim a depreciation allowance of:

a) $10,000 b) $18,100 c) $25,500 d) $96,000


Which statement about excess business losses is not correct?

a) The term “excess business losses” means losses in excess of $1 million ($2 million for joint filers) in 2019

b) The excess is treated as a net operating loss in the following year c) It applies only to noncorporate taxpayers d) The amount of excess business losses is figured at the owner level for

partnerships and S corporations With regard to meal expenses, all of the following statements are correct for 2019 except:

a) No deduction is allowed for the cost of meals eaten alone in town. b) Meal costs on travel away from home can be figured using a per diem rate. c) The cost of food provided to employees in the break room is 100%

deductible. d) The deductible limit for meals away from home on business is 50%.

On deducting the cost of business gifts, which of the following limitations applies?

a) 50% of the cost of the gift b) $25 per individual each year c) $400 per individual each year d) Ordinary and necessary business expense

In general, how is the percentage of business use of a home figured for purposes of the home office deduction?

a) Ratio of home office to number of rooms in the home b) Square footage basis c) Hours worked in the home office d) Flat 10% in all cases


Which of the following is not a test for determining material participation under the passive activity loss rules?

a) Participating in the activity for more than 500 hours. b) Participating in the activity for more than 100 hours where such

participation was as much as anyone else. c) There is material participation based on the facts and circumstances for

the year. d) Having losses from the activity under $1 million.

The qualified business deduction is subtracted from:

a) Business income b) Gross income c) Adjusted gross income d) Taxable income

A factory building placed in service on May 1, 2019, is depreciated using the straight-line method over:

a) 19 years b) 27.5 years c) 39 years d) 40 years

The maximum dollar limit on the Code Sec. 179 deduction in 2019 is:

a) $500,000 b) $1 million c) $1,020,000 d) $2,030,000

In 2019, a taxpayer buys and places in service a heavy SUV costing $95,000. Assume business use is 100%. How much of the cost can be deducted?

a) $18,000


b) $25,000 c) $43,000 d) $95,000

Form 4562 is required to be filed in 2019 by an individual in business in all of the following situations except:

a) There is any vehicle depreciation reported. b) There is any new amortization reported. c) No property is placed in service in 2019 by a business with no vehicle

usage or new amortization to report. d) A Section 179 deduction is elected.

Edward Smith explores a business opportunity in January and February 2019. In May 2019, the business begins. It has start-up expenses of $80,000, costs for acquiring Code Sec. 197 assets of $125,000, cost for acquiring a lease of $10,000, and attorney’s fees for quieting title to property. Which of the following expenses cannot be amortized?

a) Attorney’s fees b) Business start-up costs c) Acquisition of Code Sec. 197 assets d) Cost of acquiring a lease

A plumbing business has an ordinary net operating loss arising in 2019. The carryback period is:

a) Zero b) 1year c) 2years d) 3years

All of the following statements regarding bad debts are correct except:

a) Nonbusiness bad debts are treated as long-term capital losses. b) In order to be deductible, a nonbusiness bad debt must be entirely

worthless.


c) To claim a bad debt deduction, the taxpayer must include a statement with the tax return containing information such as when the debt became due, collection efforts, the nature of the debt, and how the taxpayer concluded the debt was worthless.

d) Nonbusiness bad debts are deductible in the year they become worthless. The statute of limitations for claiming a deduction for a business bad debt arising in 2019 is:

a) One year b) 2years c) 3years d) 7years

Which type of income can a farmer exclude from gross income?

a) Cost-sharing payments under a conservation, reclamation, and restoration program

b) Crop insurance proceeds c) Fertilizer and lime received under a government program d) Livestock indemnity payments

Documents

1040 Preparation and Planning 6: Gross Income: Business